Investing in bonds is a critical component of a well-rounded investment strategy. In fact, investors have dubbed 2024 The Year of the Bond, citing elevated starting yields, further potential rate cuts and a better ability to hedge future stock market volatility.
Bonds offer a unique set of benefits that can provide stability and income, serving different roles based on an investor’s goals and risk tolerance. Understanding how bonds fit into a portfolio and selecting the right bond fund requires an understanding of its intended purpose and the strategies that underpin successful bond investing.
The role of bonds in an investment strategy
Bonds primarily serve two essential roles within an investment portfolio. First, they act as a stabilizer. When equity markets become volatile, bonds provide a stable counterbalance, helping to mitigate overall portfolio risk. This stabilizing effect is crucial, especially during periods of economic uncertainty when stock markets may experience significant fluctuations.
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Bonds also provide a steady source of income through coupon payments. This income can be especially beneficial for retirees or those looking to fund living expenses. For younger investors, bond income can be reinvested to further grow their portfolio.
Differentiating bond strategies
When building a bond portfolio, it’s important to keep in mind that the fixed income asset class encompasses a wide variety of security types — each with very different and unique risk and return profiles. Bond funds that invest in securities, such as Treasuries, government-agency mortgage-backed securities (MBS) and investment-grade (rated AAA-BBB) corporate bonds, are more likely to offer investors modest levels of income and returns but rank highly for their dependability, especially during economic or market stress.
On the other hand, bond funds that invest in things like high-yield or “junk” bonds, bank loans and non-government guaranteed commercial and residential mortgages offer enticing levels of income but may lead to unpleasant surprises during market downturns.
Selecting the right bonds
With so many options, what steps should you take to select the right mix of funds for your risk tolerance and return objectives? First, we recommend building a good, high-quality foundation. Investing at least 75% of your bond allocation in traditional “core” bond portfolios will help anchor an asset allocation and prevent the risk of unpleasant surprises. Pay extra close attention to the credit rating breakdown of a fund’s investments. If more than 5% to 10% of a fund’s assets are invested in securities rated below investment grade, it may carry too much risk.
Once you’ve got your portfolio’s quality ironed out, it’s important to understand a fund’s exposure to interest rate risk. For this, look for a measure called “duration.” As a rule of thumb, 1% change in interest rates will result in price fluctuation roughly equal to the fund’s duration.
Remember, however, that bond prices and yields are inversely correlated. To better understand, let’s consider a real-world example. If a bond has a duration of six years and interest rates rise 1%, the price of that bond will fall by roughly 6%. On the flip side, if yields fall by 1%, the price will increase by 6%.
Also, don’t forget to factor in the starting yield. In the above example, let’s assume the bond yielded 5%. An investor’s total returns would be about -1% and 11%, respectively. Many investors have been spooked by rising interest rates and are still heavily invested in short-term bond funds and even money market funds. With historically elevated yields, however, we believe it’s a good time to add duration to your bond portfolios. Funds benchmarked against the Bloomberg Aggregate Bond Index (aka the Agg) are likely to offer the best combination of quality and duration.
Finally, you should understand the tax implications of picking different types of bond funds. For example, municipal bonds are often exempt from federal and sometimes state taxes. This makes them an attractive option for taxable portfolios. However, for many investors, placing bonds in tax-advantaged accounts like IRAs can help minimize the tax impact of the income generated.
Current market outlook
Looking ahead, the outlook for the bond market appears quite favorable. In recent years, rising inflation has led to higher interest rates, which in turn caused bond prices to fall. However, with inflation stabilizing and even moderating, the outlook for bonds is improving. Economic data is also showing signs of moderation as the unemployment rate has edged up to 4.2% — the highest level since 2021. With the Federal Reserve having cut rates this September, the current yield environment offers a strong foundation for bond returns, and any decrease in rates would likely further enhance these returns.
Choosing the right bond fund involves understanding the stabilizing role of bonds, prioritizing high-quality securities and staying informed about market conditions and risks. For those considering bond investments, we recommend this research-driven approach — and keeping these principles in mind can lead to more informed and successful investment decisions.
Johnson Investment Counsel cannot promise future results. Any expectations presented here should not be taken as any guarantee or other assurance as to future results. Our opinions are a reflection of our best judgment at the time this material was created, and we disclaim any obligation to update or alter forward-looking statements as a result of new information, future events or otherwise. Johnson Investment Counsel is not responsible for the accuracy or relevance of any unapproved content originated or inserted by the publisher of this article, such as hyperlinks and potentially other data.
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