Investors should still consider holding bonds, even though yields are still near all-time lows.
High-quality bond investments can still provide diversification benefits, and there’s a cost to waiting for rates to rise.
Bond ladders can help investors stay invested in the bond market regardless of the interest rate environment.
Bond investors face a challenging environment. The federal funds rate is back near zero, the 10-year Treasury yield remains stuck in a 0.5%-to-0.75% range, and inflation-adjusted (real) yields are . Meanwhile, yields on riskier fixed income investments, such as high-yield bonds, have fallen as unprecedented fiscal and monetary policies have helped to prop up the economy and the financial markets.
Despite those challenges, we believe fixed income investments still have a place in a well-diversified portfolio. It may seem tempting to keep your money in cash, to take on more risk in the stock market, or to look to lower-credit-quality investments to potentially earn higher returns, but we continue to believe that high-quality, intermediate-term bonds should serve as the core of your fixed income holdings. Then, depending on your risk tolerance, higher-yielding investments can be added as a complement to those core holdings, but only in moderation.
Despite the challenges, we believe investors should consider the following reasons to hold bonds today:
- They offer potential diversification benefits.
- Short-term rates are likely to stay lower for longer.
- Yields aren’t near zero across the board, but higher-yielding bonds come with higher risks.
On top of these benefits, we believe are one way to stay invested during these challenging times, as we discuss below.
Bonds offer potential diversification benefits
High-quality bonds like U.S. Treasuries offer diversification benefits when added to a portfolio of stocks. Treasuries tend to be more defensive in nature, and their returns tend to have a negative correlation with stock market returns. In other words, they help “zig” when the stock market may “zag.”
U.S. Treasuries have negative correlations with U.S. stocks. While it’s true that yields are low today, U.S. Treasuries can still help serve as a buffer if the stock market were to decline. Longer-term Treasuries have historically provided some of the best diversification benefits due to their higher durations—they are more sensitive to changes in interest rates. If the economic recovery were to stumble or we witnessed another stock market decline, we believe that intermediate- and long-term Treasuries will experience larger price increases than short-term investments like Treasury bills. If the economic recovery continues, we expect intermediate-term Treasuries to hold their value, given our outlook for very easy monetary policies for the next few years. In other words, as long as the Fed keeps its benchmark interest rate anchored near zero, we don’t expect yields to rise much.
Long-term Treasuries tend to be less correlated with U.S. stocks than short-term Treasuries
Note: Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated.
Source: Schwab Center for Financial Research with data from Morningstar Inc. Correlations shown represent the correlations of each asset class with the S&P 500 during the 10-year period between August 2010 and July 2020. Indexes representing the investment types are: Bloomberg Barclays U.S. Treasury Index (20+ Year, 7 – 10 year, and 1 – 3 year sub-indexes), Bloomberg Barclays U.S. Aggregate Bond Index, Bloomberg Barclays Municipal Bond Index, Bloomberg Barclays U.S. Corporate Bond Index, ICE BofA Merrill Lynch Fixed Rate Preferred Securities Index, and Bloomberg Barclays U.S. Corporate High-Yield Bond Index. Diversification strategies do not ensure a profit and do not protect against losses in declining markets. Past performance is no guarantee of future results.
Short-term yields are likely to stay lower for longer
It may seem tempting to sit in cash or other short-term investments, waiting for a better opportunity to invest in bonds when yields are higher. There are plenty of reasons for investors to hold cash—for liquidity, for daily expenses, or for financial planning purposes if liabilities are coming due. But, if you’re holding cash as an investment today, we expect the yields to remain near zero for years—so, you won’t get much of a return on your investment.
The median projection from Fed officials points to near-zero rates through the end of 2022, and Fed Chair Jerome Powell has said the Federal Open Market Committee wasn’t “even thinking about thinking about raising rates.” The markets generally agree, as market-based expectations indicate a rate hike won’t occur until late 2022 or into 2023.
Market expectations point to low rates for years
Source: Bloomberg. The market estimate of the future federal funds rate using Eurodollar futures. As of 8/31/2020.
Even if the economic outlook improved considerably, we expect the Fed might think twice before hiking rates, especially after it . The change suggests that the Fed will likely maintain its zero-interest-rate policy for several more years until it sees inflation rise, rather than acting pre-emptively to address inflation expectations. Keep in mind that the Fed held rates in the zero-to-0.25% range for seven years in the wake of the financial crisis, so it shouldn’t surprise investors this time around if it holds rates near zero for a prolonged period of time.
For those tactically waiting for rates to rise before investing in bonds, there is a cost to that strategy: the opportunity cost of missing the compounding higher yields that are available today in other high-quality investments. An average five-year investment-grade corporate bond offers a yield of roughly 1% today. While that is low in absolute terms, it’s well above other short-term, liquid alternatives. Compared to a three-month Treasury bill, an investor can earn roughly 0.9% more per year. While that might not seem like much, it slowly adds up over time, as you can see in the hypothetical example below.
There is a cost to waiting for rates to rise
Source: Bloomberg and the Schwab Center for Financial Research. Hypothetical scenarios using the yield on a 3-month Treasury bill of 0.1% and the yield-to-worst of an average 5-year corporate bond of 1.0%. The third scenario assumes the Fed funds rate is increased to 1% in year three, resulting in 3-month Treasury bill yield of 1.0%. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product, and the example does not reflect the effects of fees.
Not all bond yields are near zero
Bond investors can look beyond U.S. Treasuries or certificates of deposit to earn higher yields, and the level of yields can vary depending on how much risk is involved.
Riskier fixed income investments currently offer higher yields
Source: Bloomberg, as of 8/28/2020. Yield represents yield-to-worst for all investments except preferred securities which represents yield-to-maturity. Indexes representing the investment types are: High-Yield Corporates = Bloomberg Barclays U.S. Corporate High-Yield Bond Index; Preferred Securities = ICE BofA Fixed Rate Preferred Securities Index; EM USD Debt = Bloomberg Barclays Emerging Market USD Aggregate Bond Index; Investment Grade Corporates = Bloomberg Barclays U.S. Corporate Bond Index; Municipal = Bloomberg Barclays Municipal Bond Index; Agency MBS = Bloomberg Barclays U.S. MBS Index; U.S. Aggregate Bond Index = Bloomberg Barclays U.S. Aggregate Bond Index; Intl Ex-USD = Bloomberg Barclays Global Aggregate ex-US Bond Index. Past performance is no guarantee of future results.
We still prefer higher-rated, higher-quality investments like investment-grade corporate and municipal bonds for the bulk of a bond portfolio. Their yields appear relatively attractive, as they are higher than the five-year average leading up to the pandemic. For investment-grade corporate bonds, we look at credit spreads, or the amount of yield offered above a comparable Treasury yield. For the municipal bond market, we look at the municipals-over-bonds, or MOB, spread, which compares the yield of a municipal bond to a comparable Treasury security.
Investors with a higher tolerance for risk can add higher-risk investments in moderation, but should keep in mind that these are more prone to price declines if the economic outlook should deteriorate. During the stock market selloff that troughed in March, high-yield bonds, preferred securities, and emerging-market debt all suffered declines of 15% or more. While we generally have a neutral outlook on most of the aggressive-income1 fixed income investments, we do find emerging market bonds relatively attractive today. However, we suggest limiting your allocation to any of the more aggressive income investments to avoid too much risk.
Bond ladders can help take the guesswork out of investing
A bond ladder is a portfolio of individual bonds that mature on different dates. Picture a ladder with several rungs and spacing between the rungs. The individual bonds are the rungs and the time between maturities is the spacing between the rungs. By spacing out the maturities of the various bonds, investors don’t get locked into one interest rate.
A bond ladder can help take the guesswork out of investing because it helps investors manage whatever interest-rate environment arises. If yields rise, the maturing bonds can be reinvested at those higher yields. If yields fall, maturing bonds will unfortunately be reinvested into lower-yielding bonds, but the existing bonds will still provide the higher yields that were initially locked in.
One of our mantras is that “time in the market is more important than timing the market.” A bond ladder—and a disciplined approach to keeping it intact—can help investors stay invested through whatever interest environment arises.
What to do now
Don’t abandon your bond holdings because of the low yields they offer. Rather, make sure you own the right bonds to better help you navigate today’s challenging environment:
- Consider high-quality, intermediate-term holdings for the diversification benefits they provide.
- Remember that waiting in cash has a cost, as income payments from higher-yielding alternatives can compound over time.
- Reach for yield … but cautiously. Consider adding some riskier fixed asset classes as long as any allocation is in line with your risk tolerance.
- Consider bond ladders to help take the guesswork out of investing and to stay invested.
1 Aggressive income is a strategy that seeks to generate income through investing in securities that tend to be less correlated with the general bond market, including, but not limited to, preferred securities or emerging-market bonds.
What You Can Do Next
- Follow the Schwab Center for Financial Research on Twitter: @SchwabResearch.
- Talk to us about the services that are right for you. Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch, find a consultant or open an account online.
- Explore Schwab’s views on additional fixed income topics in Bond Insights.