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Like most financial assets, bonds are having a bad year. But experts say that also means there's opportunity in fixed income.
Bonds are generally considered a less-risky asset than stocks. Still, they haven't been immune to the selloff investors experienced this year that has sent all three major stock market indexes tumbling into bear markets. The Federal Reserve has been raising interest rates to battle high inflation and most recently hiked rates by three-quarters of a percentage point for the third time in a row. The Bloomberg Global Aggregate Index of government and corporate bonds is down more than 20% since the beginning of the year, signaling the global bond market has entered a bear market for the first time in around three decades.
As Tom Lauricella of Morningstar recently pointed out, bonds seem like "a tough sell" right now.
"This year is well on its way to being the worst in modern history for bond investors," he wrote mid-September.
But there's an upside: Falling bond prices means rising bond yields. On Wednesday, for example, the yield on 10-year U.S. government bonds briefly hit 4% for the first time in around 14 years.
"For the first time in a long time, there is actually income in fixed income," says Kathy Jones, chief fixed income strategist at Charles Schwab.
Here's what those high yields mean for bond investors, and how you can take advantage.
Bond prices and bond yields
First, let's quickly run through how bonds work. Companies and governments issue bonds when they want to raise money, so when you buy a bond you're essentially lending money to that entity.
That company or government is agreeing to pay you back your principal (the amount of money they're borrowing from you) when the bond matures on a specific date, as well as regular interest payments (called the coupon). For example, if you buy a bond for $1,000 that matures in 10 years and pays a 4% interest payment annually, you'll receive $40 annually until the 10 years are up, at which time you'd also get back your $1,000. The yield is the overall return you get on a bond.
Bonds tend to be considered safer than other financial assets like stocks and, barring an issuer defaulting on their debt, you can rely on the income.
There is a wide variety of types of bonds, with different payment timelines and minimum investments. Most bonds offer fixed coupon rates. But the interest on the Series I Savings Bond or I bond, for example, is made up of both a fixed rate and an inflation rate, which can change every six months. The duration on bonds vary, too, with most falling between one year and 30 years.
Enter the current state of affairs. While the fed fund rate hikes are intended to cool the economy, they also bring down the price of financial assets like stocks and bonds.
But when bond prices move down, bond yields move up. The reasoning comes down to supply and demand within the bond market. When there is less demand for bonds, new bond issuers have to offer higher yields to attract buyers. Meanwhile, bonds with lower yields that are already on the market become less valuable by comparison.
What exactly does this all mean for bond investors today?
"It's a bad year if you held bonds starting on January 1st," explains James J. Burns, certified financial planner and president of JJ Burns & Company. "It's a great year for someone who's got cash to invest."
Stocks vs. bonds: What should I buy?
One of the reasons people invest in bonds is that they play an important role as a moderator of risk in a portfolio, says Dave Plecha, global head of fixed income at Dimensional Fund Advisors.
And actually moderating how much risk you take is much easier in bonds than in stocks: If you want to have a low-volatility bond portfolio, you buy bonds with shorter durations and higher credit quality, Plecha explains. (Credit quality refers to how likely a borrower is to repay their debt. Shorter-term bonds are less volatile because you're not locking up your money as long.)
Stocks, on the other hand, potentially have higher returns but also are considered more risky in the short term.
"That's why young people lean so heavily — as they should — toward equities," Plecha says. "They have such long horizons and the luxury of time."
Typically when you're young, financial advisors tend to say you shouldn't have a lot of money invested in fixed income. Instead, you may want to establish an emergency fund first, and then invest money you won't need in the near future in stocks. But as you get closer to retirement, you likely want to invest in bonds because they allow you to preserve capital and have more predictability.
"When they retire, people tend to add more bonds because they need more current income, and they don't really want to ride out the ups and downs of the market as much," Jones says.
If you're far from retirement but have short-term goals, bonds may also make sense, she adds. For example, if you're planning to pay for a child's education, you might want to buy some bonds that mature during that child's school year so you can use that money to help with the bill. The same goes for plans to buy a home anytime soon.
It's important to note that bonds do still come with risk. For example, there's the risk that the Fed will continue to hike interest rates, which could lead to further losses for bond investors.
Opportunity in the bond market
For those focused on income, the current state of the bond market is an important opportunity, Jones says: "Gone are the days when you could only get 1% or 2%. Now you can get four or 5% or higher."
And you don't have to take a tremendous amount of risk to get that income, she adds. So don't take big swings.
"If someone is really trying to stretch for something high yielding really because it looks shiny, that may be where there could be a bit more trouble," says Adam Shealy, senior investment analyst at Homrich Berg. While higher-yield bonds may also see higher returns, there is greater risk that the issuer will default on the debt.
The prospect of constructing a portfolio of high-quality bonds with yields around 4% to 5% without having to take a tremendous amount of duration risk is an attractive opportunity for investors, Jones says. High-quality bonds include investment-grade — those that receive higher ratings from credit agencies and are considered less likely to default — corporate and municipal bonds as well as Treasuries.
Rob Waldner, fixed income chief strategist at Invesco, told Morningstar's Lauricella he's also in favor of higher-quality bonds. He noted that the fundamentals are "very solid" for municipal bonds — those issued by state and local governments, perhaps to cover the cost of the roads you drive to work or your local school — and that he's wary of lower credit quality bonds, which could suffer during a recession.
And Treasury bills — short-term bonds issued by the government nicknamed T-bills — are "suddenly sexy," in the words of Bloomberg this week. These are low-risk, cash-like investments that mature within a year.
Investors who are keeping too much of their money in cash "have no clue" what they could be making in bonds, according to Burns.
"Treasuries are like the best thing in town right now if you want to keep your cash short term," Burns says, adding that one-year Treasury bills are yielding almost 4%. "That is unbelievable."
How to buy bonds
There are many different ways to buy bonds, and the process is sometimes (but not always) as easy as buying stocks or ETFs. You can head to TreasuryDirect.gov to buy bonds directly from the federal government. Money has a whole guide to buying I bonds this way.
You can also buy bond funds, which invest in many different securities as opposed to just one, which can help limit risk. Morningstar has a ranking of what it considers the best bond exchange-traded funds (ETFs).