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EVERYBODY SEEMS to hate bonds right now. Can you blame them? Inflation is at a four-decade high, the Federal Reserve is sure to hike short-term interest rates two weeks from Wednesday, and geopolitical jitters make owning high-yield bonds all the riskier. On top of that, returns have been awful since the start of 2021.
But maybe we should take a contrarian approach. Almost everybody should own at least some bonds. Yields have improved significantly. The benchmark 10-year Treasury yield, which fell to 0.52% in August 2020, is now at 1.99%. For those who want bond exposure, there’s plenty of inexpensive exchange-traded funds (ETFs) on offer from firms like BlackRock, manager of the iShares funds, and Vanguard Group.
For instance, if you want a proxy for the entire U.S. Treasury market, there’s iShares U.S. Treasury ETF (symbol: GOVT) with its yield to maturity of 1.88%. Treasurys are usually a great diversifier for stocks, though that hasn’t been the case this year. Vanguard Total Stock Market ETF (VTI) is down 8.3% in 2022, while the iShares fund is off 4.1%.
The broad U.S. bond market, as measured by iShares Core U.S. Aggregate Bond ETF (AGG), has an average yield to maturity of 2.43%. While far less than today’s inflation rate, that yield is comparable to the 2.54% inflation rate expected by investors over the next 10 years. The iShares fund is the largest bond ETF in the world, with nearly $90 billion of assets. Second is another U.S. broad bond market fund—Vanguard Total Bond Market ETF (BND), with a bit over $80 billion of investor assets.
Where else might you seek income? Some individuals, particularly those in high tax brackets and who live in high tax areas, look to the municipal bond market. You don’t need a broker to go out and find you individual muni bonds. Instead, you might take a do-it-yourself approach, which is cheaper and easier, and buy a fund like iShares National Muni Bond ETF (MUB), which yields 1.65%. That relatively low rate is effectively higher since you shouldn’t owe federal income taxes on the interest received.
Continuing down the bond boulevard, let’s check out corporate bonds. Today, iShares Broad USD Investment Grade Corporate Bond ETF (USIG) offers a 3.21% yield. That beats the five-year expected inflation rate of 3.02%. But be warned: Corporates, even the high-quality segment, can decline when stocks fall.
What about high-yield debt, otherwise known as junk bonds? A fund like iShares iBoxx High Yield Corporate Bond ETF (HYG) contains low-rated bonds that might default during bad economic times. Will investors be compensated for taking that risk? The yield to maturity on the iShares fund is 5.59%, which should help offset the money inevitably lost to bond defaults. Still, stock investors don’t get much of a diversification benefit from junk bonds, which almost always decline when the S&P 500 drops.
Meanwhile, if we want to head overseas, we might check out a fund like iShares International Treasury Bond ETF (IGOV), which tracks an index composed of non-U.S. developed market government bonds. Don’t get too excited—the yield is just 0.76% and 2021’s total return was a dreadful -9.24%. Many foreign developed countries, such as Japan and Germany, had negative interest rates on their debt over the past few years, plus the dollar strengthened in the currency market, depressing the return of foreign investments for U.S. holders.
What if I told you that a 6% yield was there for the taking? I’m not talking about super-safe Series I savings bonds, but rather emerging market debt, which is a growing piece of the $130 trillion global bond market. Currently, iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) sports a yield to maturity of 6.06%. There’s significant risk, though. The fund was down 13.3% peak to trough in the past year, dividends included. If you own an international bond fund, you may already have an allocation to emerging market debt.
Investing in bonds is easier than ever, thanks to so many low-cost ETFs. In fact, the amount of choice can seem overwhelming. Perhaps the simplest approach is to own U.S. and international broad bond market index funds. That way, you have exposure to all areas of the global bond market, from government bonds to high-quality corporates to junk bonds and even emerging market debt.
Unsure how to proceed? You might take your cues from the allocation of Vanguard Target Retirement 2030 Fund (VTHRX). It has a 35% allocation to bonds and cash, with some 24% invested in the Vanguard Total Bond Market Index Fund and almost 11% allocated to Vanguard Total International Bond Fund. Investors with a high risk tolerance might put less into bonds, while more conservative individuals could go higher than the Vanguard fund’s 35% exposure.
Professionals who trade bonds for a living are willing to accept 1.86% on 10 year treasuries. In your opinion, what is that telling us? That rate is far below expected inflation over the next 2-3 years. It’s fairly easy to find stocks with an equal dividend yield albeit with significant downside risk to the stock price. All they telling us stocks are greatly overpriced? Seems like we are looking at a long period of negative interest rates in terms of real return.
I’m not so sure about negative real rates for a long period. We could easily see short-term rates in the 2.5-3.0% range in a couple years with inflation back in the 2.25-2.75% range.
You should never equate a stock’s dividend yield to the rate on Treasuries.
Thanks for the run-down Mike. I got burned in the ’90’s with a bad bond fund by an outfit called Strong, and for too long avoided bond funds. They definitely have a place in most portfolios, including mine, and today the choices are better than ever. The only real question is how much of a portfolio is to be allocated to them, which of course will vary depending on one’s time horizon (at least, it should).
Right now, in my retirement accounts I hold VTIP (short duration TIPs) and in the taxable accounts I hold VRIG (a short-duration variable rate ETF).
I think inflation is temporary and we are overall in a deflationary environment (owing to demographics, national debt etc.) It may not be a bad idea to buy more of a total bond market fund (BND) at this juncture.
I like VTIP as well (duration about 2.7 yrs, Y-T-M about 1.2%, one year return about 5%, Y-T-D return about 1%)…..BTW we have a visiting Arabian grey four-year-old gelding in our pasture named Purple Rain – my husband calls him „Prince“, he‘s a real sweet horse…….
I personally like preferred stocks from good credits as a bond alternative, but they are a very tricky investment. You have to thoroughly understand the strange characteristics of preferreds in order to use them properly, and I wouldn’t go higher than 10% of assets. But you can get a nice little stream of qualified-dividend income if you know what you are doing.
I wouldn’t recommend preferred funds, because the fund managers tend to take risks to advertise a high yield, only to lose a lot of principal when there is a major negative event. Because of the nature of the investment, these losses will be locked in, while common-stock funds will recover when the market recovers.
Thanks for the thorough review. I’m starting to feel like my wife and I retired into the dreaded “sequence of returns” risk scenario.
Thanks, Rick. I’m not so sure. Even if returns are not great in the next few years, that will just make many niches of the market all the more attractive from a valuation perspective. Ex-US markets are not expensive and even small caps are arguably not highly-priced.
True, the problem is when you are de-cumulating assets. What do you sell.
Hard to say that yields are better now at 2% if inflation is 7%-seems like a bad deal to me. I’m not a fan of bond funds since there is rarely a maturity date-they just keep reinvesting. I also didn’t see any mention of duration or how much the funds could be hurt with rising rates. The I-bonds at 7% and 1-year T-bills at 1.15% seem okay here and if rates rise they don’t get hurt. Could be worse as I see the Russian interest rates jumped to 20% today.
Future inflation is what matters. Seven percent inflation has already happened. The market sees inflation at 3% per year for the next five years and pretty close to the historical norm for the 5-10 year period.
Even if inflation is high, there’s nothing you or I can do about that. It’s a risk when people see high inflation, then take on way more risk than they should just to try to “beat inflation.”
Also, with bond funds, it’s a myth that they have infinite duration risk. When rates rise, of course bond fund NAVs drop. But they also reinvest maturity bonds into higher-yielding bonds. If rates steadily rise, that’s a great thing for long-term bond investors since it means finally getting a decent yield (like we had in the 80s, 90s).
Duration works both ways, too. If rates drop, high-duration bonds will provide a big potential return. There’s no law that says rates must go higher from here.