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 annual coupon payments.)
And secondly, they provide diversification. As bonds tend to have a low correlation to the stock market, they generally help reduce losses during bear markets and reduce the overall level of volatility.
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2022 tested some of these assumptions. We started this year with yields too low across much of the bond market to offer significant income. And due to the aggressive tightening of the Federal Reserve, bonds were also less effective than usual in providing diversification. iShares Core US Aggregate Bond ETF (AGG (opens in new tab)), which many in the industry consider a proxy for the “bond market,” is down about 14% year-to-date as of Nov. 21.
But here is where it gets fun. After an extraordinarily difficult 2022, bonds are starting to look interesting based on both of the above criteria. Yields are now near multi-year highs across the yield curve. With investor concerns now migrating from inflation risk to recession risk, bonds may once again hedge portfolios that have traditionally been in the coming months.
But where do investors start looking? The “bond market” is not a single monolith. Bonds can be divided and subdivided in almost infinite ways based on maturity, credit quality, calling characteristics and a host of other criteria.
“Choosing bonds or bonds for your portfolio ultimately depends on your specific needs and your macro outlook,” says Douglas Robinson, founder and president of RCM Robinson Capital Management, a registered investment advisor based in San Francisco, California. .” revenue strategy. “In particular, your choice of maturity will come down to your time horizon and when you need the money as well as your outlook on inflation.”
It also comes down to risk tolerance. If your main motivation is high yield, you might want to take your chances on lower credit-quality issuers. But if diversification and safety is your priority, you’ll want to stick with the safety of US Treasuries, because these are the only true “risk-free” bonds on the market. Let’s break it down.
Start with Maturity
Insurance companies and pension plans generally have time horizons measured in decades. In some cases, the time horizon might even be “infinite.”
But this is not the case for an individual investor. Human life is what it is, a time horizon of a couple of years or a decade or two will generally be it.
Think about your own goals. If you are looking to finance a college fund for a newborn, then your maximum time horizon should be about 18 years. If you are looking for a down payment for a future home, your horizon might be just a couple of years at most.
As a general rule, you don’t want to buy long-dated bonds in the 20-30 year range because they can be very sensitive to interest rate movements. As a case in point, consider the iShares 20+ Year Treasury Bond ETF (TLT (opens in new tab)). Because of the big increase 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, this type of move could be perfectly fine if you’re looking to aggressively trade as opposed to investing for safety and income.)
Another factor to consider is the shape of the yield curve. In a normal market, the yield curve slopes upward, meaning that long-term yields are always higher than shorter-term yields.
This is not the case today, as the yield curve is inverted. Depending on the specific type of credit you happen to look at, shorter-term bonds may actually yield more.
As an example, as of this writing, Treasury in the range 1-3 years yield about 4.7% on average. The average yield on 20+ year Treasury bonds is a decent bit lower than that at around 4.2%.
Weighing your portfolio too heavily in short-term bonds 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 benefits of current production against the risk of reinvestment. And generally, the best way to do that is to simply diversify, spreading your investment across a ladder of bond maturities.
Credit quality matters too
If you want absolute security, buy only US Treasury securities and be done. But being willing to accept a little credit risk in the bond market will generally mean a higher potential yield. And the more risk you take, the greater your potential return.
For example, as of this writing, the average yield on 3-5-year Treasury was about 4.2%. The average yield on 3-5-year AA-rated corporate bonds was approximately 4.7%, and the yield on 3-5-year BBB-rated bonds was approximately 7.6%. And of course, if you are willing to accept the risk of non-investment-grade “junk” bonds, the yields are even higher, even if this higher yield comes with a higher risk of default.
Which Bond Is Right For You?
Every investor will be a little different. But as a general rule, if you are going to err, it is better to err on the side of better quality and shorter time to maturity. By all means, diversify and include some longer bonds and some more speculative credit ratings. But if you value safety, keep your portfolio heavier for short-term, high-quality issues.
Today, you can find the yield of almost 5% of safe, boring treasury with just a handful of years of maturity. And frankly, that’s hard to beat.