Consider preferred securities, international funds, and TIPS to ease the sting of bonds behaving badly again.
Bonds are causing trouble again as yields rise and prices slump. This isn’t a sequel to 2022, the last time bonds really tanked. But it pays to make some moves to protect yourself.
Bonds are under pressure as investors worry that inflation is here to stay. Consumer prices rose 3.8% year over year last month as the war in Iran dragged on, keeping oil prices elevated and pushing up inflation.
Core inflation strips out volatile food and energy prices and isn’t moving up as much. But the market is getting worried that inflation will be higher for longer. That’s why long-term bond yields, which reflect inflation expectations years in the future, are rising sharply. Yields on the 30-year Treasury bond recently touched 5.2%, up from 4.6% just before the Iran war. Long-term yields haven’t been this high since July 2007.
Investors may have bad memories of 2022, when the U.S. bond market posted a 13% decline, after interest income. Yet there are key differences now.
For one, the Federal Reserve is very unlikely to hike interest rates like it did in 2022 to combat inflation. Futures markets see a 4o% chance of a 0.25 point increase and 15% probability of a 0.50 point bump. That would sting, since bond prices and yields move inversely, but it would be peanuts compared with the 4.25% rate hike in 2022.
What’s more, yields are starting from much higher levels than in 2022. That year, a rapid rise off ultralow rates sent yields soaring and prices diving. The losses swamped the pickup in yields, leading to total-return losses.
Higher starting yields now provide more cushion. And they offer an attractive entry point for investors buying bonds today.
“I do think you have places to hide in 2026,” says Joe Boyle, head of asset class specialists at Hartford Funds.
It’s a good time to find those nooks and crannies. Short-term bonds aren’t as interest-rate sensitive as long-term bonds and still offer attractive yields. The Vanguard Short-Term Bond exchange-traded fund, for instance, holds a mix of investment-grade debt with one- to five-year maturities.
The fund yields 3.7% and is flat for the year, after accounting for its interest income. By contrast, the iShare Core U.S. Aggregate Bond ETF, a proxy for the broad U.S. bond market, is down 1% on a total return basis. While it yields a bit more, at 4.4%, its exposure to the long end of the yield curve is dragging it down.
Preferred stocks are another option. These hybrid stock and bond securities generally offer yields north of 6%. The iShares Preferred and Income Securities ETF is up 2.2% this year and yields 6.3%.
Treasury inflation-protected securities are designed to help investors keep pace with inflation. They underperformed in 2022, when losses dwarfed higher yields, but they are worth a look today.
Short-term TIPS are attractive now, says Rebecca Venter, senior fixed-income client portfolio manager at Vanguard. They pose less interest-rate risk than TIPS on the longer end of the spectrum and offer “real” yields well above the inflation rate.
The iShares 0-5 Year TIPS Bond ETF, for instance, is up 1.7% this year on a total return basis, and has an inflation-adjusted yield of 1.8%.
Like it does with equities, diversification matters with bonds. Rising yields are a global phenomenon, but that doesn’t mean every country is the same. Latin America is a natural-resources powerhouse, supplying much of the copper and lithium the world needs. The iShares J.P. Morgan USD Emerging Markets Bond ETF offers dollar-denominated exposure to global bonds, including nearly 4% each in Brazil and Mexico. It’s flat for the year and yields 5.8%.
If bonds continue to fall, they would pose a drag on the classic portfolio of 60% stocks and 40% bonds. That mix didn’t fare well in 2022, when both stocks and bonds dropped together. The two asset classes tend to be more correlated when inflation runs hot, and we could see them moving in tandem this year, as well.
That doesn’t mean you should ditch bonds. If the economy tilts into a recession, then bonds should return to their traditional role as ballast in portfolio. Inflation would also need to calm down, but it usually does when the economy weakens sharply.
“You’re going to see that negative correlation when you need it most and there’s a steep economic decline,” Venter says.
Write to Elizabeth O’Brien at elizabeth.obrien@barrons.com