Are Bonds A Good Investment?

The bond market can be challenging - especially in today's environment. What newer investors need to know: when interest rates go up, bond prices move down. And that is what happened early this year in the bond market. The 10 year U.S. Treasury moved from a low of about 0.5% to 1.75%. This has happened several times over the past 30 years.

Interest rates may pause for now

The dramatic move earlier this year has now stabilized because much of the news is now priced in. The market is anticipating the Federal Reserve to raise interest rates in a little over a year from now, which is still a year earlier than the Fed has indicated. Below you can see where the Fed estimates rates to be vs where the market estimates rates to be.

There is definitely room for rates to continue rising as the economy continues to recover and progress, even if it is now at a slower pace. If rates do unexpectedly jump again it would probably be in response to higher inflation readings. Another wrench in rates rising is the U.S. bond yield rates compared to those of other international developed countries. U.S. rates are still significantly higher than many interest rates in Europe and Japan (which are near 0). This drives demand to the U.S. bond market and creates more pressure on yields.

U.S. Treasury yields compared to those of other developed countries

For the rest of 2021 it wouldn't be surprising to see the 10 year yield to be in the 2% to 2.5% region. This would be consistent with what the Federal Reserve's long-run target would be.

Making money in this bond market

The low yield of 0.5% last year is likely to be the lowest reading for many years. We probably won't see rates rise in a straight line, it's going to be a much more choppy ride. But what if rates go from 0.5% to 6% in the next 20 years? A staggered strategy might be a good strategy: the key is to buy bonds at shorter time durations with the ability to reinvest the proceeds as rates rise.

What should an investor do?

  1. Reduce duration. Shorter is better. Bonds with shorter durations (2 year instead of 5 year) tend to be less volatile as rates move higher.

2. Consider bond ladders. Spreading bond maturities out over time allows investors to capture more income as yields rise. Don't try and time the bond market. This is a way to average into higher yields while still being invested in the bond market.

3. Use TIPS to hedge against inflation. Treasury Inflation Protected Securities help hedge against inflation risk. TIPS are designed to keep up with the pace of inflation measured by the Consumer Price Index (CPI).

Lastly, focus on your overall financial plan. Bonds are in your portfolio to counterbalance against risker more volatile investments and provide stable cash flows. This isn't the best time to be a bond investor, there is no doubt about that. If I had to choose, I'd choose stocks over bonds all day. But an investor's risk tolerance, lifestyle, and many other factors are going to play into their stock/bond allocation. Personally, I'm keeping my bond durations very short and waiting for a better time when bonds will yield more bang for my buck.