Jill On Money: Don’t ditch your bonds

Bonds are back in the news this summer, as yields have climbed and mortgage rates remain stubbornly high.

Before explaining why this is happening, here is a quick bond primer:

Think of a bond as an IOU. When you buy one, you’re lending money — to the U.S. government, a city, or a company — and in exchange, the entity promises to pay you back the full amount (called the “face value” or “par value”) on a specific date, plus regular interest payments (the “coupon”) along the way.

You will often hear that bond prices move in the opposite direction to interest rates. Here’s why: When interest rates rise, existing bonds that have lower, locked-in rates — become less attractive, so their prices fall.

When rates fall, those older bonds with higher rates look more appealing, and prices go up. That’s why bond prices can fluctuate between the date of purchase and maturity. That said, if you hold a bond to maturity, none of that matters — you get your interest payments and your principal back, full stop. The price swings only matter if you’re selling before the finish line.

Ten years ago, I wrote about a strange occurrence in the bond market: Some global investors were lending money to governments and accepting negative interest rates. In practice, they were buying a bond at a higher price than they would receive at maturity, the exact opposite of what normally occurs. Who would strike such a lousy deal?

Those who believed that global central banks would continue to buy bonds to stimulate economies (things were still pretty pokey in the aftermath of the financial crisis and the Great Recession) and therefore, the price of bonds would keep rising and yields would fall. Additionally, there was little or no inflation to erode purchasing power, so people were willing to accept lower yields.

Flash forward to the present, where that period seems like a distant memory. This summer, the yield on 30-year U.S. Treasury bonds rose to its highest level since 2007 (over 5.3 percent).

But the level is not the whole story. Ben Carlson of Ritholtz Wealth Management notes that the average yield in the past 50 years is 6.2%, so not so far off from where we are today.

Torsten Slok, chief economist at Apollo, notes that one driver of higher rates is inflation, which remains higher than the Federal Reserve’s target. As a result, the central bank is more likely to keep interest rates higher for longer.

Add in recent tax cuts and heavy spending, and the government keeps piling on debt. To service it, the Treasury has to issue more bonds — and to induce new buyers, yields have to be higher. All else equal, large federal deficits increase the supply of Treasury debt and put upward pressure on yields as investors demand higher returns to absorb the extra borrowing.

Does all of this mean you should ditch your bonds? Not so fast.

For most investors, bonds are a component of their accounts and usually (though not always) provide a ballast against stock volatility. Before you write in, I know that in 2022, stocks and bonds BOTH fell.

As Dan Lefkowitz of Morningstar puts it, “bonds don’t always diversify equity market risk, but they often do.” For those of you who were investing amid the financial crisis and its aftermath, bonds were salve to a lost decade for stocks.

As I said in a recent article, I do not believe in market timing, so if you are tempted to ditch your bonds, remember that they are generating income, cushioning volatility, and keeping your overall portfolio in line with your risk tolerance.