Bonds might not seem attractive to investors given the environment of low interest rates. But depending where investors are in their lives, these traditionally safer investments may be just right.
There are a couple of ways to make money on bonds, also known as fixed-income investments. First, investors get paid an interest rate of a certain percentage of the bond’s face value. Also, bond prices move up and down, just like stocks.
Interest rates and the risk premium, the amount paid to investors for taking on the risk of the debt, are main price drivers for bonds, says Wayne Schmidt, chief investment officer at Gradient Investments in Arden Hills, Minnesota.
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To seek value, investors want to buy bonds when interest rates are dropping, as bond prices move inversely with rates, Schmidt says. That lets bonds move up in value.
For corporate bonds, which generally offer higher yields than Treasury bonds because they are riskier, investors will want to buy them when the difference between their yield and the yield on Treasuries is narrowing, Schmidt says. That also means the bonds are appreciating.
The yield on bonds will increase if the company that issued the debt has trouble and its credit risk increases — widening the bonds’ difference with Treasury yields, he says.
“Bonds play a pretty strategic role in the portfolio,” says Meb Faber, a co-founder and chief investment officer of Cambria Investment Management in El Segundo, California.
There are differences. Not all bonds are created equal, Faber says. He cites differences in Treasury bonds, corporate bonds and emerging market bonds.
In the early 2000s, investors could own a bond portfolio that would yield 6 percent, Schmidt says. But these days, low interest rates mean bond yields are also low, so investors should be aware of what they’re getting into, he says.
The 10-year Treasury note is yielding 1.7 percent.
To get that 6 percent yield now, investors would have to buy corporate bonds from companies with higher credit risks, he says.
Now is not a good time for investors looking for value appreciation to get into bonds because of low interest rates from the Federal Reserve, Schmidt says. And he doesn’t think bonds will get cheaper anytime soon, as he sees low interest rates continuing for three to five years.
“There’s not a lot of upside, and there’s not a lot of income in today’s market,” Schmidt says.
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However, bonds offer more stability than stocks, and bonds can be the way to go for investors who are looking to protect their portfolio and control volatility, he says.
But that has to come with lower expectations about earnings, he says.
Others may want to own bonds that mature in certain years so they can target income around life events, Schmidt says, such as retirement income or paying for a child’s college tuition.
Faber recommends most investors don’t try to time the market when they buy or sell bonds, but keep have them as part of a strategic portfolio allocation.
“Investors are horrific at timing,” he says.
Aside from owning individual Treasurys because of their low credit risk and liquid market, picking individual bonds should be left to institutional buyers, Schmidt says.
For retail investors, he recommends sticking with bond mutual funds or exchange-traded funds, which offer diversification and liquidity. He prefers ETFs because they are generally cheaper than mutual funds.
Assume risk for more earnings. For people willing to take on more risk, Schmidt recommends high-yield bonds in a portfolio because their income advantage offers value compared to the lower-earning Treasurys and investment-grade corporate bonds.
“You’re trading off credit risk for income,” Schmidt says.
One high-yield ETF that Schmidt likes is the VanEck Vectors Fallen Angel High Yield Bond ETF (ticker: ANGL), a portfolio bonds that had been investment grade. These bonds tend to perform better and have fewer defaults, he says.
He also likes Guggenheim Investments’ BulletShares series, praising the combination of high-yield bonds with diversification and targeted maturity dates.
Faber, who co-manages the Cambria Sovereign Bond ETF (SOVB), recommends holding foreign bonds, saying investors can get a 6 to 7 percent yield with high-yield sovereign bond funds.
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In addition to sovereign debt being a good allocation right now, Faber says high-yield and high-quality corporate bonds are also trading at an acceptable spread over Treasury yields. Those are more equity like, but investors shouldn’t expect these more-risky investments to have the same safe-haven qualities as Treasurys, he says.
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