The historic bull market for bonds (or fixed income) appears to be dwindling with yields on newly issued bonds nearing historic lows.

Some investors have reacted to the lower yields in bonds by pulling money out of the bond market, but is that really a smart idea?

In this article, we are going to go over key aspects you need to know about bonds.

What Are Bonds?

According to investor.gov, “A bond is a debt security, similar to an IOU. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time. When you buy a bond, you are lending to the issuer, which may be a government, municipality, or corporation. In return, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal, also known as face value or par value of the bond, when it ‘matures’ or comes due after a set period of time.” The bond issuer will use these funds to support operating cash flow, invest in capital investments, or pay off debt.

How Bonds Work

Governments and corporations can issue bonds in order to raise money for their operations. For the bond investor, they are basically giving the issuer a loan that will have to be paid back in the future. The bond investment will have to be repaid at face value and on a specified date, along with the interest rate payments that are usually collected twice a year.

Unlike investing in stocks, bonds do not give the bond investor any ownership of the company. That means if the company fluctuates in growth, the payments the borrower makes to the bond investor do not change (except in the case the borrower cannot make payments and defaults). Many investors choose to invest in bonds because it is typically a secure investment strategy for a portion of their portfolio (this will be discussed more below).

What Are the Different Types of Bonds?

While there are many different types of bonds from which to choose, some of the most common include Treasury bonds, municipal bonds, corporate bonds, and other governmental bonds.

How to Invest in Bonds

As you ponder the current environment for investing bonds, below are seven things that you should keep in mind:

1. As an individual investor, bonds should still play a critical role within a diversified portfolio when it comes to your overall investment strategy.

Don’t give up on high-quality bonds! When stocks are taking a beating on Wall Street, high-quality bonds tend to hold their value. The most recent examples came during the market meltdown of 2008/2009 and the COVID-19 downturn in the spring of 2020. Adding bonds helps diversify a portfolio and can provide stability for equity holdings that will be more volatile during inevitable stock market downturns. Remember, asset allocation is key for a successful investment portfolio. You want a lot of different assets in your portfolio.

2. Negative bond returns are rare for high-quality bonds.

While there is a lot of chatter today about a bond market “bubble,” bond market losses have historically been much less severe and less frequent.  Since 1973, for example, intermediate-term bonds (as measured by the Barclays U.S. Government/Credit Bond Index – Intermediate Term) have experienced just two negative-return years (in 1994, a total return of -1.9% and in 2013, a total return of -0.9%), compared to ten negative years for the Standard & Poor’s 500 Index (lowest total return was -37.0% in 2008).

3. Stick with the right kind of bonds.

When looking for higher-yielding bonds, it’s tempting to gravitate to riskier bonds, such as high-yield corporate bonds, when U.S. Treasuries are offering such minimal yields. However, avoid the temptation. Reserve the risky part of your portfolio to stocks which historically have provided higher returns than speculative, low-quality bonds that need to offer higher yields to attract investors to take on the increased risk.

4. Don’t go too “long” on bonds.

To avoid interest rate risk (the value of a bond will fall as interest rates increase), consider sticking with high-quality bonds that have short- to intermediate-term exposure. Having these bonds in your portfolio will lessen the impact of a sudden rise in interest rates. Remember that bond prices and yields move in the opposite direction.

5. Understand the risks of “reaching for yield.”

Investors who “reach for yield” by choosing bonds with longer maturities will likely suffer the most in a rising interest rate environment.

6. Don’t try to predict rates.

With the Federal Reserve (Fed) reinforcing its low interest rate mandate, intermediate-and long-term interest rates may stay near current levels for quite a while.

Our current economic conditions would not suggest that we will face materially higher interest rates in the short term. Here’s why:

• Unemployment remains stubbornly high with the ongoing COVID-19 pandemic.
• Inflation has been relatively low since the 2008 global financial crisis.
• GDP growth continues to underwhelm.

These factors (and others) suggest that rates could remain relatively low for some time.

7. Don’t get discouraged.

Even though high-quality bonds are yielding relatively low yields, they still serve a very important component to a well-diversified portfolio.

Before putting money into bonds, it is important to understand that investing in bonds have risks. Some notable risks include the following:

• Interest Rate Risk: Interest rates typically have an inverse relationship with the price of a bond. If you lock in an interest rate on a bond and interest rates in the market subsequently rise, your bond may become less valuable (i.e., if your current bond yields 1% and the market rate is 2%, investors would likely offer to buy your lower-yielding bond at a discount). The inverse is typically true as well (a decrease in market interest rates may make a bond you already own more valuable).
• Reinvestment Risk: When a bond matures and you receive your par value back, you may have to reinvest in a lower-yielding bond compared to the yield of your original bond.
• Liquidity Risk: For certain types of bonds, there may not be an active market to sell the bond after issuance. There is typically less liquidity risk with government bonds than corporate bonds.
• Default Risk: If a bond issuer is unable to pay the interest of principal on a bond, an investor may lose part or all of their investment. There is typically more default risk in corporate bonds compared to government bonds.
• Inflation Risk: If prices in the economy rise (inflation), the real returns of a bond can deteriorate.

If you would like to discuss how bonds play a role in your investment portfolio, reach out to our financial advisor team.