For the past decade, historically low-interest rates have made bonds a low-returning asset category, despite their other benefits. From 2013 to 2023, bonds have returned a dismal 1.08% per year, on average. That’s their worst ten years of performance ever in absolute terms—and near the worst relative to stocks, which returned 12.53% per year, on average, over the same period according to an analysis by Nasdaq.com.

Most people buy bonds for safety and income, but bonds haven’t provided much income over the last decade. That’s because interest rates have been so low. At their low point in July 2020, 10-year Treasury bonds yielded just 0.57%, their smallest return in 60 years.

Yet now that interest rates are rising again, it may be time to consider bonds. The case for bonds has become especially compelling as the stock market turns more volatile. Although bonds should always make up part of a diversified, prudently managed asset allocation, they’re especially relevant now. Here’s what you need to know about this asset class and how it can enhance your portfolio.

Bond Basics

What is a bond? Basically, it’s a loan. When you buy a bond, you provide capital to the issuer—which can be a government, a company or a government agency—in return for a stream of regular interest payments.

Unlike when you buy a stock, you’re not purchasing ownership of the company, and you won’t benefit if its value increases. But you are guaranteed steady income through interest payments, as well as the return of your capital, as long as the issuer doesn’t default or stop making these payments.

Total Return: How Do Bond Investors Earn Money?

There are two components to bond returns: yield and appreciation. Together they make up what is called total return.

The yield part is relatively straightforward. Most bonds have fixed interest rates that are set when they are issued (though some so-called “floating rate” bonds adjust their interest payments to match prevailing rates).

The appreciation comes into play whenever the value of this stream of future interest payments changes because of rate increases or decreases.

For instance, say you buy a bond that pays out 5% in annual interest payments for 10 years. Now imagine that the Fed lowers interest rates and similar bonds, issued later, now pay out only 4%. Your bond, with its higher-than-market interest payment, becomes more valuable. Its price will go up. The opposite happens when rates increase. Your older bond becomes less valuable because other bonds on the market are paying higher rates.

The rule of thumb, then, is that when rates go up, bond prices go down and vice versa. Investors’ exposure to this risk is called “interest rate risk.” It’s one of the main risks entailed in bond investing.

Maturity: When Do I Get My Money Back?

Your bond also has a “term,” that is a period of months or years during which you receive interest payments. After that term has expired, you get your initial investment back.

You can divide bonds into three basic categories by maturity.

• Short-term bonds: maturities of up to five years.
• Intermediate bonds: maturities of five to 12 years.
• Long-term bonds: maturities of 12 or more years.

Generally, the longer your bond’s maturity, the higher rate you’ll receive, because you’re taking on more risk by locking up your money. (Currently, because the Federal Reserve is raising rates so aggressively, short-term rates are higher than long-term rates, a phenomenon known as an “inverted yield curve.” This is quite unusual and probably transitory.)

Longer-term bonds also fluctuate more in price than short-term ones when interest rates change. Shorter-maturity investments, like money market funds and short-term bond funds, are generally considered less risky and more conservative than longer-term bonds and funds.

Credit Risk: How Certain Am I That I’ll Get Paid?

One final risk affects bond returns: credit risk. This quantifies the risk that an issuer will stop making interest payments or even fail to repay the principal when the bond’s term is over. Of course, some issuers are more likely to default than others. For instance, the default risk for U.S. government-backed Treasuries is near zero; that risk is much higher on bonds issued by companies with shaky financial underpinnings.

Ratings agencies like Standard & Poor’s and Moody’s measure this risk through credit ratings of individual issuers. For instance, Standard & Poor’s assigns ratings from AAA (the highest) to C (the lowest) to issuers, while Moody’s uses an Aaa to C scale. Generally, lower-rated bonds pay higher interest rates.  

Why Are Bonds a Good Option Now?

If you haven’t already allocated a portion of your portfolio to bonds, it might be a good time to consider doing so, for several reasons.

Interest rates have driven bond yields up, so these investments generate more income than they have in the past. Consider that just two years ago, the benchmark 10-year treasury bond yielded under 2%; now it is yielding about 4%.

Many investment experts believe that rates are at or near the peak in the current cycle. If they come down, bond prices will rise, further enhancing returns.

Bonds are generally a low-risk investment, even in times of market volatility. With bond yields now higher than they have been for some time, investors can earn equity-like returns, without the same level of risk.

Using Bonds in Your Portfolio

Adding bonds to an all-stock portfolio can smooth out returns and reduce exposure to sudden shifts in the equity market. That’s because bonds have historically performed differently than stocks under a range of market conditions.

For instance, stocks may do well when the economy is growing strongly and inflation is ticking up, but bonds typically lag during this kind of environment. Conversely, bonds do best when rates are falling, often a period of economic stagnation in which equities struggle. So diversifying across both stocks and bonds can lower overall portfolio risk.

A bond allocation also produces moderate but consistent returns over time, especially compared to stocks. For the 40-year period between 1976 and 2016, U.S.-issued bonds produced average annual returns of just under 4% — or roughly half the return of the S&P 500. However, variation in those returns, as measured by standard deviation, was considerably lower than in stocks, with U.S. bonds at about 6% and stocks at 16%. So investors got about half the return with only a third of the volatility.

And finally, bonds often provide protection during sharp market downturns. In 2008, for instance, stocks plummeted 36% as the Great Recession took hold, but Treasury bonds advanced more than 20%, according to data collected at NYU. The same was, unfortunately, not true during the latest stock market decline of 2022, when the S&P 500’s 18% drop was nearly matched by Treasury bonds’ 17% retreat, but in general, broad asset class diversification helps in the most volatile market environments.

You can add bonds to your portfolio by investing in a bond mutual fund, or a bond exchange-traded fund (ETF). These funds will generally have a mix of different individual bonds and bond types. Investors can also purchase and hold individual bonds.

Different Types of Bonds

Bond investors can choose from many different fixed-income strategies to fine-tune their exposure to risk and optimize their potential for return. Generally, you can find bond mutual funds or ETFs that are focused on one kind of bond individually, or that may contain a mixture of different bond types. Talk to your financial advisor about which of these types of bonds might make sense for you.

Government bonds: These are the safest and most conservative of all bond investments since they are backed by the full faith and credit of the issuing government. Income from government bonds is taxable at the Federal level but is often exempt from state and local taxes. Current yields on U.S. Government bonds range between 4% to 5% depending on their maturity.

Municipal bonds: Municipal bonds, or “munis” are issued by city, state, and local governments. These are often called “tax-exempt” bonds because their income is not taxed at the Federal, State, or local level. Yields vary by issuer and maturity and credit quality. AAA-rated munis currently yield an average of 2.70% to 3.60%, depending on maturity.

Corporate bonds: Corporate bonds are considered slightly riskier than government bonds since even high-quality companies occasionally default on loan obligations. However, this category includes only top-tier U.S. companies or investment-grade bonds. These are companies rated BBB or better by S&P (or Baa or better by Moody’s). Moody’s Aaa-rated bonds, the highest quality category, currently yield 4.60%.

High-yield bonds: These are the riskiest and highest-yielding of all bond investments because they are loans to companies with above-average risk of default. Because of the added risk, these bonds typically yield about four percentage points higher than Treasuries. However, this differential fluctuates depending on market conditions. Currently, the ICE Bank of America U.S. High Yield Index, a broad measure of high-yield bonds, is yielding about 8.57%.

Is It Time to Think About Bonds?

Bonds can be incredibly valuable tools for your overall portfolio. They can play an important protective role, helping to lower the risk profile of your overall investments, while still generating some returns—and they’re especially compelling now. Contact Trinity Wealth Management today to discuss your options for allocating some of your investments to bonds.

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