Outside the Box: What’s the best bond investment when interest rates are so low?

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Q: With the interest rates down and so very low what is the best thing to do with bond portfolios going forward?

A.: The basic trade-offs for bonds haven’t changed even with rates low. Bonds are obligations to pay certain amounts at certain times. What to do should be driven by why you want to own bonds. The two most common reasons are to receive an income yield and to provide stability to the portfolio. These two goals tend to conflict.

Some people own bonds because they primarily want income. The current environment doesn’t provide much income so many of these folks are seeking higher yields.

To get a higher yield, one way has been to buy bonds that mature farther out in the future. These longer maturities usually offer higher yields but not always. As I write this, even the 30-year Treasury is sporting a yield under 1%.

The downside to buying longer term bonds is that when interest rates rise, the value of the bond will drop. If you need to sell before maturity, you can lose money. The longer the term, the bigger the loss. I’ll skip the math here but a bond’s sensitivity to interest rate changes can be calculated via something called duration. With an effective duration currently of about 26 years, the 30-year Treasury bond would be expected to lose 26% of its value if interest rates on 30 year maturities rose by 1%.

The other common way to get more yield is to buy bonds from issuers with lower credit ratings. The yield available from these issuers is higher because there is some level of doubt whether the interest or maturity payments will be made in a timely manner. The prices of corporate bonds for instance, can fluctuate greatly based upon perceptions of corporate health or fears of a recession.

You can see this now as the economy hits the brakes due to COVID-19 and high-yield bonds suffer. For instance, through March 18, the SPDR Bloomberg Barclays High Yield Bond ETF JNK, +0.76%, an exchange-traded fund that tracks high-yield bonds is down over 17%. That is far from stable.

So, investors that want more yield, must be willing to take on more risk of loss from changes in interest rates or effects of credit quality. This is a classic example of how markets provide trade-offs between risk and reward.

By contrast, bondholders who want to own bonds primarily for stability can receive that stability if they do the opposite of yield seekers. They typically buy bonds on the shorter end of the maturity scale to reduce the risks from rising rates and they stick with high quality credits, like strong governments and agencies.

The downside to holding bonds mostly for stability is that you usually have to live with lower rates. Over the long term, this stability approach is good for the blood pressure but not good against inflation. Staying ahead of inflation over long periods is a job much better suited for diversified stockholdings but, of course, stocks have some downside to them too.

If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.

Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.