Over the last few years, investors have become accustomed to near-zero interest rates.

The benefits of this include historically low rates on mortgages and loans. On the other hand, investors were earning next-to-nothing on bank accounts, savings vehicles, and some types of bonds.

This quickly changed in 2022 as the Federal Reserve (the Fed) steadily increased interest rates throughout the year in an effort to curb inflation.

The 10-year U.S. Treasury rate, a benchmark measurement for interest rate movements, moved from 1.5 percent at the end of 2021 to almost 4 percent at the end of 2022.

Let’s talk about how bonds work and why now may be an opportune time to include them in your portfolio.

How Do Interest Rates Affect Bonds?

While higher interest rates are good for earning more interest on fixed-income investments, the path to get there can be difficult.

2022 was particularly tough for fixed-income investors. The Bloomberg U.S. Aggregate Bond Index suffered a 13 percent decline, the worst in its history as the Federal Reserve steadily increased interest rates throughout the year.

When interest rates rise, bond prices typically fall.

For example, let’s say an investor owns a bond with a ten-year maturity and a 2 percent coupon rate. If interest rates increase to 3 percent, the bond decreases in price. Why? The market will view the 3 percent bond as more favorable compared to the lower-paying 2 percent bond. The 2 percent bond will lose value and the price will decline.

Individual Bonds or a Mutual Fund for Fixed Income?

When it comes to fixed income, investors have two primary options: owning individual bonds or owning a bond mutual fund.

A bond mutual fund provides investors with the opportunity for diversification as the fund may hold hundreds of individual bonds. They also offer professional management and research with lower transaction costs and minimum investment requirements. Mutual funds are a good option for investors who seek a diversified bond portfolio of smaller dollar amounts.

However, there is a potential for increased price fluctuation with bond mutual funds. All investors in the fund may not have a long-term approach and may sell out of the fund when the market hits rocky times. The fund manager may have to sell bonds to meet redemption requests, which could lead to lower prices and losses for remaining investors.

To offset these drawbacks, owning individual bonds directly in your portfolio may be a good choice.

Individual bonds offer a higher degree of certainty for both principal and interest payments. An investor can select a bond that meets their specific maturity date. Moreover, individual bonds allow an investor to hold the bond to maturity. They can “put blinders on” to interim price movements. They will receive the periodic interest payments as well as the principal at maturity, regardless of market fluctuations.

One caveat of owning individual bonds is the expertise required to select and trade the bonds. Because the bond market operates in more of an auction format, it is important to utilize professional management so you receive favorable pricing and execution.

What About Bond Ladders?

Investing in a bond ladder is another option for fixed income investors. A bond ladder is a portfolio of individual bonds with staggered maturities.

This approach works particularly well in a period of rising interest rates. As each bond matures, an investor reinvests the proceeds in another bond with a maturity at the end of the ladder.

This allows investors to take advantage of rising interest rates and also provides greater flexibility in adjusting the strategy as the market changes. Also, the individual bonds provide a higher degree of certainty for principal and interest payments.

Short-Term vs Long-Term Rates

While interest rates have risen significantly over the last year, shorter-term rates have increased much more than long-term rates.

For example, U.S. Treasuries maturing in the 6-month to 1-year timeframe are now yielding roughly 5 percent. However, a longer-term 20-year Treasury is yielding 4 percent.

This means idle cash can be invested in shorter term maturities at more favorable rates than we’ve seen in the past. Both individuals and businesses are now able to make an attractive rate of interest on short-term cash deposits.

Conclusion

Since interest rates have risen significantly over the last year, now may be an opportune time to utilize bonds within your portfolio. Not only do bonds provide diversification in a well-allocated portfolio, they can now provide favorable income again.

If you have questions about bonds in today’s environment, we’re here to help. We can provide a second opinion or be a sounding board to help you make a plan to reach your financial goals. Get in touch with our advisors anytime by calling 855-855-5455 or emailing [email protected].