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Tempered Expectations for Bond Returns: Why Hold Bonds?

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RANDY FREDERICK: Bond yields remain at historically low levels, and it’s been eight months since the Fed last implemented a rate hike. Collin Martin, a fixed income strategist at the Schwab Center for Financial Research, joins me for the August 9 Schwab Market Snapshot to explain why even in this difficult environment it’s still important to own bonds. Welcome back, Collin.

COLLIN MARTIN: Hi, Randy. Thanks for having me back.

RANDY: So, Collin, it seems like the Fed would really like to raise interest rates another quarter-point, but that’s difficult when other central bankers around the world are still in easing mode. And, worse yet, some investors are going places that they normally wouldn’t go in order to try to find yield. But you say that they should still own bonds. So it looks like low rates are probably going to be here for a while. What should investors be doing, and why should they be holding bonds right now?

COLLIN: It may seem like the same old song, but we think there’s almost always reasons to be owning bonds. We see three key benefits to fixed income investments—diversification, relative price stability and income. So even though yields are very low right now, the income they provide is still positive.

And many highly rated and high-quality fixed income investments tend to have negative correlations with riskier investments like stocks, meaning their prices usually move in opposite directions. So this can help smooth out portfolio returns during volatile market environments. But even though yields are very low and makes it more difficult for investors looking to go into the fixed income markets now, it’s been great for bond holders, because total returns have been very strong this year.

RANDY: Well, let’s expand a little bit on that subject of returns. I think kind of most people know that bond prices and bond yields kind of move opposite each other—and Treasuries have fallen quite a bit this year, and Treasury prices are up—and, of course, that means they’ve generated some pretty solid total returns. But some of the riskier parts of the bond market have actually done pretty well, too. Now, that’s a little bit out of the ordinary, isn’t it?

COLLIN: You know, it is unusual, Randy. Often we see the higher-quality parts of the market performing well at the expense of the riskier parts of the market. That hasn’t been the case this year.

One reason could be, you know, easy monetary policies across the globe, which is pulling government yields down and their prices up—so we’re seeing strong performance for things like U.S. Treasuries. But as those Treasury yields fall, investors looking for relatively higher yields have been moving down the risk spectrum going into lower-rated investments and then pushing those prices up. So that’s why we’re seeing returns strong almost across the board.

Now, it’s important to recognize that this only matters for investors who actually sell their investments. If you hold a bond to maturity, these price swings might not matter. But if you hold a bond and you look to sell in the secondary market, you could realize some of that price change.

RANDY: So if I understand you correctly, it sounds like you’re saying it’s been a pretty good year, so far, for the bond market. But you’re also saying that some bondholders may be living on borrowed time. So if that’s true, which ones are most vulnerable? And what should those investors be doing right now?

COLLIN: We do see risks with the riskier parts of the market, like high-yield bonds. We think their strong performance could be driven more by investors reaching for yield, as opposed to strong or improving corporate fundamentals.

And we’re also a bit cautious on long-term Treasuries. Now, they are one of the best performers of 2016, but they also tend to be the most sensitive to interest rate changes. Now, we’re not expecting long-term bond yields to rise much from here, but because of that interest rate sensitivity, even just a slight rise in long-term yields could lead to significant price declines.

But what this means for investors is expectations should be tempered. With yields so low, it’s going to be difficult to see prices go much higher from here, and we think it’s more likely that yields move up than down from the current levels.

RANDY: Well, you mentioned Treasuries, and it seems like we often talk about Treasuries as, quote, the bond market. But as we’ve already touched upon, there are really plenty of other fixed income investments out there that have a very wide range of interest rates. So what advice can you offer to investors who have been out there sort of reaching for yield?

COLLIN: Investors that have been reaching for yield in the riskier parts of the market—especially if their risk tolerance can’t handle it—might want to consider moving up into higher-quality investments.

So for investors looking to go into fixed income now, we like highly rated high-quality bonds with short- and intermediate-term maturities. We like TIPS, or Treasury Inflation-Protected Securities, to help protect your portfolio from future inflation. And we like investment-grade municipal bonds.

Even though there are some negative headlines out there about a few select municipalities, overall, we think the broad market is in good shape, and they can help offer attractive after-tax yields for investors in high income tax brackets. But, with performance strong for the year, investors who have bonds might see a rise in their portfolio value. It could be a good time for a portfolio checkup. So check with a Schwab fixed income specialist to make sure that your fixed income investments are still in line with your goals.

RANDY: Thank you, Collin. Great stuff. Listen, if you want to read more from Collin you can do that in the fixed income section of Schwab.com. And don’t forget, you can follow me on Twitter @RandyAFrederick. We’ll be back again. Until next time, invest wisely. Own your tomorrow.

Important Disclosures

Please note that this content was created as of the specific date indicated and reflects the authors’ views as of that date. It will be kept solely for historical purposes, and the authors’ opinions may change, without notice, in reaction to shifting economic, business, and other conditions. The information presented does not consider your particular investment objectives or financial situation (including taxes), and does not make personalized recommendations. Supporting documentation for any claims or statistical information is available upon request.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third-parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Schwab does not provide tax advice. Clients should consult a professional tax advisor for their tax advice needs.

Schwab Center for Financial Research (“SCFR”) is a division of Charles Schwab & Co., Inc.

Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.

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