How to Build a Bond Portfolio

But there may be some confusion regarding how to actually invest, given how large and complex the bond market is. It might seem tempting to wait for better opportunities to invest, as the Federal Reserve likely isn't done hiking rates and because many Treasury yields have actually fallen over the past few months.

Below we'll address five key points about bond investing, ranging from "how" to invest to "why now?"

1. Bonds for income and capital preservation. These are two of the key reasons to own high-quality bond investments. Most bonds make semiannual interest payments that are known in advance based on a percent of the par value. A missed interest payment generally triggers a default for the issuer, whereas stock dividend payments are discretionary and can be raised, lowered, or eliminated based on the outlook for the company. Defaults for highly rated investments tend to be rare, however; default risk is highest for investments with sub-investment-grade, or "junk," ratings.

Bonds also have fixed par values and maturity dates, so barring a default, investors know in advance what they'll receive and when.

Bond prices can still rise and fall in the secondary markets, which might catch investors off guard because bonds are often considered "safe" investments. Bonds have interest rate risk, so their prices can rise and fall with the changing interest rate environment, as the chart below illustrates.

Shown below is the price of a Treasury note that matured in May 2022. It was issued in May 2012 at its $1,000 par value—meaning it was a 10-year note when issued—and matured at its $1,000 par value. As you can see, it was a bumpy ride along the way, illustrating that even high-quality investments like U.S. Treasuries can experience ups and downs. Yet the Treasury note matured at its par value in May 2022, meaning the principal was preserved, while still paying 1.75% annually to bondholders. Holding bonds to maturity can help investors "look through" any potential price changes, as those price increases and decreases are ultimately unrealized. Keep in mind that this illustration is for one individual bond. Bond mutual funds and ETFs generally don't have set maturity dates or par values, so there are additional considerations for investors when deciding what approach is most appropriate.

We suggest most investors first focus on "core" bonds, or high-quality bonds, like U.S. Treasuries, certificates of deposit, mortgage-backed securities, investment-grade corporate and municipal bonds, as well as Treasury Inflation-Protected Securities. These generally have low to moderate credit risk, depending on the investment, and tend to offer more diversification benefits when combined with stocks in a portfolio compared to bond investments with more risk. Think of core bonds as the "ballast" to your portfolio. We suggest they make up the bulk of your fixed income holdings.

Over the past 10 years, U.S. Treasuries have had a negative correlation with the S&P 500^® index, while other high-quality investments like mortgage-backed securities, municipal bonds, and the Bloomberg U.S. Aggregate Bond Index have had relatively low correlations. Riskier investments at the bottom of the chart below have high correlations with U.S. stocks, so if the stock market is falling, it's likely that these investments are as well.

Riskier investments like high-yield bonds and preferred securities also tend to have higher correlations with stocks, so they don't provide many diversification benefits to an overall investment portfolio. A high correlation means that their total returns tend to move in the same direction as stock total returns. That can be a good thing when stock prices are rising, but when stocks are falling they tend to fall as well.

4. No one rings a bell at the top. When yields hit their peak, they rarely stay there for a sustained period of time. Over the last 30 years, the 10-year Treasury yield tended to fall once it hit its peak, and that trend appears to be intact today. After touching 4.25% in October 2022, the 10-year Treasury yield has steadily declined over the past few months, dropping as low as 3.37% on January 18^th. We believe that 4.25% yield was the cyclical peak and that yields should continue to decline as the year progresses. However, it's likely to be a bumpy road with bouts of volatility.

Waiting for yields to rise is also an attempt to time the market, which is something we rarely suggest for long-term investors. Just as we wouldn't suggest a stock investor wait for the market to bottom—potentially missing out on gains if the bottom already happened—we don't suggest investors wait for the perfect time to invest. Yields for high-quality investments are at their highest levels in years, so we suggest investors take advantage by considering bonds today.

5. Why invest in intermediate- and long-term bonds if short-term yields are higher? Despite the inverted yield curve, we think it makes sense to gradually extend the average duration of your bond holdings.

The chart below highlights this conundrum, with one- and two-year Treasuries offering yields of 4.6% and 4.1% respectively, while the 10-year Treasury note only offers a 3.4% yield. We still suggest intermediate- and long-term bonds to reduce the potential for reinvestment risk, which is the risk that short-term bonds could be reinvested at lower yields.

While the Fed is still hiking rates, the markets are already pricing in the potential for rate cuts later this year if growth and inflation fall too much. In that scenario, bonds that mature in the next few years could be reinvested at lower rates. So while accepting lower yields with longer maturities might be a tough pill to swallow, it helps reduce the risk of even lower yields down the road.

Not all yield curves are inverted, however. The corporate and municipal bond curves are more upward-sloping, so investors can still be rewarded with higher yields by considering longer-term bonds in those markets.

Schwab clients may search for individual bonds that meet their investment objectives and investing time horizon. For investors considering bond funds, the Mutual Fund Select List or ETF Select List are two good places to start. Separately managed accounts offer professional management, but investors actually own each individual bond.