Why high yields make bonds better investments now

You don’t have to be a financial wizard to get guaranteed returns of more than 7 percent on your money for decades to come. All you had to do was buy a 30-year US Treasury bond in the last nine months of 1994.

And if you were lucky with the timing and bought this bond in early November 1994, you could have received more than 8 percent interest per year.

There were treasures elsewhere in the investment-grade bond market. Tax-free municipal bonds paid more than 6 percent, and corporate bonds carried interest that was even higher.

This kind of gems are not available now. Although interest rates have risen significantly, I am not convinced that we are experiencing a 30-year peak with a glut of deals like the happy bond buyers did in 1994.

But I see parallels. After months of horrific losses, buy-and-hold long-term bond investors can expect relief from disappointing returns in the coming years.

What’s more, with short-term Treasury yields well above 5 percent, 10-year Treasuries yielding in the 4.9 percent range and investment-grade corporate bonds above 6 percent, fixed income investments are attractive—certainly compared to the ultra-low interest rates of a few years ago.

This is not exactly good news. Rising interest rates hurt borrowers, increasing the cost of mortgages, credit cards, car loans and more. As in 1994, the rise in bond yields has been linked to the Federal Reserve’s tightening interest rate cycle and concerns about the future of inflation.

Bond losses, then and now, are a consequence of rising market yields: prices and yields move in opposite directions, as a matter of fundamental bond math. Precisely because yields have risen to their highest levels in more than 15 years, this is once again a good time to own and buy investment-grade bonds.

Last week’s column covered some of that. Along with many caveats, here are more ideas for investing in bonds.

I’m a buy-and-hold investor, relying primarily on low-cost index funds that track the entire stock and bond market—an approach that assumes you can afford to ride out market swings for many years.

But this won’t work for everyone. Many people don’t have horizons of a decade or more. They may be retirees who can’t handle market downturns. Or they may set aside money for a time-bound goal, such as a child’s education or a down payment on a home or vehicle.

For these and many other situations, bonds can be suitable – either through funds or through individual securities.

The primary bond fund I invest in through my 401(k) tracks the US investment grade bond universe as defined by the Bloomberg US Aggregate Bond Index. This type of fund is common in workplace retirement plans. It has been largely unchanged over the past five years, but has suffered losses of more than 5 percent, on an annualized basis, over the past three years. However, I’m sticking with it.

This involves risk. It could lead to further losses if interest rates rise much more. That’s okay with me because I’m in it for the long haul. But you may not want to put up with market dips.

So consider safer alternatives.

With current interest rates, money market funds are a good option. The return on the 100 largest money market funds tracked by Crane Data averaged 5.17 percent, up from nearly zero in 2020 and just 0.6 percent in June 2022.

Fees matter, especially for fixed income investments where returns are typically in the single digits. Vanguard’s fees are low, and one of its money market funds yields 5.3 percent.

Money market funds are not insured by the government, but they do hold government securities, especially Treasury securities. Finance textbooks describe government bonds as risk-free assets, although I can’t make that claim with an honest face. US government credit ratings are no longer pristine. Already this year, the government has come close to shutting down or, even worse, breaching its debt ceiling.

Likewise, if you’re shopping around, bank certificates of deposit and high-yield savings accounts can be good choices, with guarantees that are as secure as U.S. government loans.

Another approach is to buy government bonds that you hold until maturity. Last week, the two-year note hit its highest yield since 2006: 5.2 percent. The yield could rise further – it could also fall, no predictions here – but it’s already an attractive payout.

Trading government bonds can be dangerous: you can suffer losses if interest rates rise. So if you’re risk-averse, stick to short-term Treasuries or low-cost, diversified short-term bond funds, which typically hold securities with maturities of one to three years.

You can buy Treasurys through a broker — watch out for fees — or without a broker at Treasury Direct. The site isn’t slick, but it doesn’t charge fees. There you can get savings bonds, both classic EE bonds and inflation-adjusted I bonds, as well as a range of inflation-adjusted and nominal government bonds.

Read the fine print though. I found the EE Savings Bonds intriguing. Although they offer an interest rate of just 2.5 percent, compared to 4.3 percent for I bonds, there is a sweetener. Hold EE bonds for 20 years and the government guarantees you’ll double your money. That amounts to an effective, unadvertised interest rate of about 3.6 percent, but only if you hold the bonds that long. Although the yield on I bonds is now higher, they reset every six months.

Then there are standard Treasuries, ranging from one-month bills to 30-year bonds, offering higher yields than investors have received in years.

It can be tempting to buy a 20-year Treasury bond yielding more than 5.2 percent with the intention of holding it to maturity.

Whether it’s a brilliant purchase or one you might regret in a few years because interest rates have gone up a lot is a question I can’t answer.

But if it’s any consolation, people in 1994 didn’t know where interest rates were going either. Most articles about the bonds then were overwhelmingly negative. “A Painful Year of Higher Interest Rates” was the headline of a feature article in the New York Times.

In 1995, the Fed created a rare “soft landing” for the economy by tamping down inflation without triggering a recession and cutting interest rates. A soft landing is the Fed’s goal this time around, too. But of course we don’t know if it will get there.

What is inescapably true, however, is that for investors interest rates are much more attractive than they were a few years ago. There may be better opportunities ahead, but now is a good time to buy.

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