The real value of bonds

July 13, 2022

WHEN INTEREST RATES RISE, the price of bonds tends to decline. That’s just what’s been happening this year as the Federal Reserve hikes rates in an attempt to tame inflation, leaving investors wondering: “What place does fixed income have in my portfolio now?”

The role of bonds in your portfolio hasn’t changed, says our Chief Investment Office. If anything, it may have become more critical. “Especially during uncertain economic times, bonds remain an important defense for long-term investors looking to diversify and balance riskier assets,” says Chris Hyzy, Chief Investment Officer, Merrill and Bank of America Private Bank. And after years when yields remained near zero, retirees and others may once again find bonds to be an attractive source of steady, reliable investment income.

Two recent reports from the Chief Investment Office (CIO), “Why Own Fixed Income in a Rising Interest Rate Environment?” and “Understanding and Managing Fixed Income in a Rising Rate Environment,” detail some ways bonds can help long-term investors achieve their goals. Here, Hyzy and Matthew Diczok, head of fixed income strategy in the Chief Investment Office for Merrill and Bank of America Private Bank, answer key questions many bond investors have now. Watch the video below for more insights from Diczok.

What risks do falling bond prices pose for my portfolio?

Buyers naturally prefer newer bonds paying higher yields — that’s why, as interest rates rise, the price of existing bonds, pegged to a lower rate, declines. But falling prices should be of concern mainly to investors who buy bonds in hopes of selling them before maturity, Diczok says. “For those who invest and hold onto bonds for diversification, stability and income, price fluctuations have less impact,” he notes. “You still receive the same steady income you expected, along with return of principal when the bonds mature.”

And keep in mind that higher interest rates generally mean higher income, or yield, from the bonds you purchase. One way to capture those higher yields is through bond laddering, buying a series of bonds at different maturities. When one “rung” of bonds matures, you can reinvest in a new one paying potentially higher yields (assuming rates continue to rise). While laddering may be a good option for investors who buy individual bonds, Diczok says, those who invest in bond funds will naturally benefit from the same laddering effect, since funds continually buy new bonds at different maturities.

How can bonds help to diversify my investments?

One common misconception is that when stocks perform poorly, bonds always perform well, and vice versa. That’s usually — but not always — the case, Hyzy says, and investors should not be surprised, especially during volatile years, if bond and stock prices temporarily decline or rise at the same time. “The diversification value of bonds doesn’t come from an automatic inverse relationship with stocks, but because they operate independently,” he adds.

Those differences bear out over time, with bonds historically holding up well through extended stock declines. And a key diversification benefit has less to do with performance than with the nature of the assets. While stocks can lose all or most of their value, bonds (except in cases of default) return the principal to the investor when the bond matures.  

What types of bonds should I consider now?

“For the purposes of diversification and mitigating risk, the focus should be on high-quality bonds,” Diczok says. “These include U.S. Treasurys, agency mortgage-backed securities (which are backed by the federal government), investment-grade corporate bonds and investment-grade municipal bonds.” While no investment is risk-free, these bonds may come close. He adds, “The chance of individual high-quality bonds defaulting is extremely low, and investing in a very diversified fund of high-quality bonds helps reduce that risk even further.”

For some investors, lower-quality corporate bonds or emerging markets bonds may offer the potential for higher yields. Yet, much like stocks, these are higher-risk investments that should be viewed as a separate investment category from the bonds you rely on for diversification and stability, Diczok adds.

Could bonds become a reliable source of retirement income again?

In recent years, when extremely low interest rates prevailed, retirees and others seeking investment income have had to seek income from higher-risk alternatives such as dividend-paying stocks. That’s changing, Diczok says. “While today’s higher rates may be concerning for consumers and the larger economy, they do offer retirees the potential for better, more reliable income than we’ve seen in the past,” he adds. “We see pension funds and other plans that invest on behalf of retirees taking advantage of higher interest rates.”

If you’re in or near retirement, you may want to hold bonds with longer rather than shorter durations, since they typically pay higher rates, Diczok advises. “With shorter-term bonds, you lose more to inflation each year.”

Could bonds protect my portfolio from inflation?

While higher yields are certainly welcome at a time when consumer prices are rising, “it’s important not to ask too much from bonds,” Hyzy says. Bonds paying a fixed rate of interest won’t keep pace if prices continue to rise. “Stocks, real estate, commodities and real assets may provide better protection against rising prices,” Hyzy says.

Thus, it’s important to stay invested in a diverse array of stocks and other assets as well, he notes. “The most important role of fixed Income in a portfolio is to help mitigate losses in market downturns,” Hyzy adds, “and investors should try to resist the temptation to remove high-quality bonds from portfolios.”

Keep up with investing insights from Hyzy and the Chief Investment Office by tuning in regularly to the “CIO Market Update Audiocast Series.”