The bond market fulfills two main roles for investors.
For starters, bonds generate income. (Or, at least, most do. The vast majority of bonds pay semi-annual coupons.)
And second, they provide diversification. As bonds tend to have a low correlation with the stock market, they generally help to reduce losses during bear markets and reduce the overall level of volatility.
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2022 has put some of these assumptions to the test. We started this year with yields too low across large parts of the bond market to provide meaningful income. And due to the aggressive tightening of the Federal Reserve, bonds have also been less effective than usual in providing diversification. The iShares Core US Aggregate Bond ETF (AGG (opens in a new tab)), considered by many in the industry to be a “bond market” indicator, is down about 14% year-to-date to November 21.
But this is where it gets fun. After an extraordinarily difficult 2022, bonds are starting to look attractive based on the above two criteria. Yields are now close to multi-year highs across the yield curve. And with investor concerns migrating from inflation risk to recession risk, bonds could once again be the portfolio hedge they have traditionally been in the months ahead.
But where do investors start looking? The “bond market” is not a single monolith. Bonds can be divided and subdivided almost infinitely based on maturity, credit quality, purchase characteristics and a host of other criteria.
“Choosing the right bond(s) for your portfolio ultimately comes down to your specific needs and macro outlook,” says Douglas Robinson, founder and chairman of RCM Robinson Capital Management, a San Francisco-based registered investment adviser. , California, specializing in bond income strategies. “In particular, your choice of maturity will depend on your time horizon and when you will need money as well as your outlook for inflation.”
It also depends on risk tolerance. If your primary motivation is high yield, you might be willing to take a chance on issuers with lower credit quality. But if diversification and safety are your priorities, you’ll want to stick with US Treasuries, as these are the only truly “risk-free” bonds in the market. Let’s break it down.
Start with maturity
Insurance companies and pension plans typically have time horizons measured in decades. In some cases, the time horizon may even be “infinite”.
But this is not the case for an individual investor. The human lifespan being what it is, a time horizon of a few years or a decade or two will usually be sufficient.
Think about your own goals. If you are looking to fund a college fund for a newborn, your maximum time horizon would be around 18 years. If you’re looking to save money for a future home, your time horizon might be a few years at most.
As a general rule, you don’t want to buy bonds with very long maturities in the 20-30 year range, as they can be extremely sensitive to changes in interest rates. As an example, consider the iShares 20+ Year Treasury Bond ETF (TLT (opens in a new tab)). Due to the sharp rise in bond yields in 2022, the exchange-traded fund (ETF) is down more than 30% this year, actually losing more than the S&P 500 stock index. (Of course, that kind of move could be a great fit if you are looking to trade aggressively rather than investing for security and income.)
Another factor to consider is the shape of the yield curve. In a normal market, the yield curve slopes upward, which means that long-term yields are always higher than short-term yields.
This is not the case today, because the yield curve is inverted. Depending on the specific credit quality you are considering, shorter term bonds may actually yield more.
As an example, at the time of this writing, Treasuries in the 1-3 year range are yielding around 4.7% on average. The average yield on 20-plus-year Treasury bills is a little lower than around 4.2%.
Weighing your short-term bond portfolio too heavily introduces reinvestment risk – or the risk that your options once the bond matures will have lower yields than are available today. So ultimately your job as an investor is to balance the benefit of current returns against the risk of reinvestment. And usually, the best way to do this is simply to diversify, spreading your investment across a range of bond maturities.
Credit quality matters too
If you want absolute safety, buy only US Treasury securities and do it. But being willing to accept a bit of credit risk in the bond market will usually result in a bigger potential return. And the more risk you take, the higher your potential return.
For example, at the time of this writing, the average yield on 3-5 year Treasury bills was around 4.2%. The average yield on AA-rated 3-5 year corporate bonds was around 4.7%, and the yield on BBB-rated 3-5 year bonds was around 7.6%. And naturally, if you’re willing to accept the risk of lower-quality junk bonds, the yields are even higher, although with that higher yield comes a higher risk of default.
Which link suits you best?
Every investor will be a little different. But as a general rule, if you’re wrong, it’s better to go for higher quality and shorter maturity time. By all means, diversify and include bonds with longer maturities and more speculative credit ratings. But if you value security, keep your portfolio more focused on short-term, high-quality issues.
Today, you can get almost 5% yields in safe and boring Treasuries with only a few years to maturity. And frankly, it’s hard to beat.
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