Bonds Look Less Terrible

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If you've been waiting on the sidelines for the Fed to start hiking rates to lock in higher yields, don't wait that long. Typically what happens is the market anticipates that, particularly in an environment where the Fed is talking so much about it.

Welcome to the Barron's StreetWise Podcast. I'm Jack Howe, and the voice you just heard, that's Kathy Jones. She's the Chief Fixed Income Strategist at Charles Schwab, and she's going to talk to us about investing in bonds. Hang on, don't go. I know what you're thinking— bonds are those boring things that pay next to nothing, and they're not as fun as stocks. Those things are Mostly true, but some bond yields have suddenly jumped, and there are other income-generating investments that are looking more interesting. In a moment, we'll hear more about that from Cathy and a top money manager who specializes in income investing. Listening in is our audio producer Jackson. Hi, Jackson.

Hi, Jack.

Bond yields are up, right? A year ago, a 2-year Treasury paid just 0.2%, and recently it yielded 2.3%. Now, 2.3% isn't a return to jump for joy over, but it is a big increase from a low base, and most of that increase has taken place this year. Jackson, I understand you recently bought a bond. You're a younger guy. Is this your first bond purchase, and what kind did you buy?

Well, my very first bond purchase, although I'm pretty sure my great-grandmother gave me one of those paper bonds when I was 5.

Like a EE savings? I don't know what letters they're on now.

Yeah, they say $100 and I got excited because I thought that's what it is, but no, that's what it's worth in 20 years.

Do you have plans for that money? We'll talk about that later. What kind did you buy for yourself?

Yeah, I got another savings bond, an I bond. It yields 7.12% and it's a 30-year bond. And that That yield, it's based on inflation, so it changes over time. And you can sell the bond early and get the principal back, but you'll have to give up a few months of interest.

And how much money can you put into it?

Yeah, you can buy up to $10,000 worth, but you have to do it on treasurydirect.gov. And it looks less like a brokerage and more like you're trying to pay a parking ticket in Sheboygan, Wisconsin.

Well, I mean, hang on. There's probably some Sheboygan IT people listening. I just want to say, Jackson and I hold you folks in high regard. But okay, it's a fantastic deal. I mean, that is frankly better than anything I'm about to talk about. So we probably don't have to say anything more than that. Thank you all for listening. Jackson, you can't— Yes.

What if people have more than $10,000 to put into bonds?

You know what? That's a good point. Let's continue. Bonds are not the key to building wealth long-term. Stocks are the key for most people. Stocks represent businesses. Bonds represent financing, and businesses use financing and other ingredients to create things that are more valuable—a rising stream of cash flow, a growing base of assets, and so on. It's not a coincidence that stocks outperform other asset classes over long time periods. It's the way it has to be, or there'd be no incentive to start businesses. Most investors, however, should own some bonds, not all investors, and the percentage that investors should put in bonds is not necessarily equal to their age like you might have heard.

On my death, there's a fund for my, uh, then widow, and 90% will go into an S&P 500 index fund and 10% of Treasury bills.

That's Warren Buffett talking at a Berkshire Hathaway meeting about one day leaving money to his wife, and he's not planning for 70% or 80% in bonds because of her age. What matters most is how soon you might need the money. And since Warren is enormously wealthy, and it's safe to say we're talking about a lot of money, the chances are quite small that it will run out. I recently spoke with another investor who might not need bonds for now for a different reason. He was interviewing me for his 8th grade project.

How did you first become interested in finance?

It might have been 7th or 8th grade. I used to look at the stock tables in the Wall Street Journal. I was intrigued by what all the numbers were. Who in their right mind would just put a stack of numbers like that that filled the whole page in the newspaper? Not just one page, but it was like 20 pages of these numbers. So what on earth could be so important I figured I want to learn what the numbers mean.

I read Wall Street too every day still. So really, same with the Barrons every weekend.

And hey, when you're rich and famous, be sure to give Jackson and I jobs. All right. That's, that's all we ask.

You'll still be my go-to podcast. Don't worry about it.

That's Ethan from Iowa. His mom said he could be on the podcast. Ethan is off to a great start. If he's saving for something coming up in the next decade, like college, he should consider some bonds, but If he's saving for something several decades off, he can probably hold off for now on bonds. That's because one of the main jobs of bonds is to hold their value in the event that stocks plunge. The longer you have to invest, the better able you are to wait out a plunge until the stock market comes back. Most of us, those who are at least as old as Jackson and not as rich as Warren, should probably have some bonds or other safe money. You can talk to a financial planner about the right percentage for you based on your wealth, income, family circumstances, and so on. Now, the rise in bond yields that I mentioned earlier, that's happening because inflation is running at elevated levels and the Federal Reserve has started to raise interest rates and is expected to continue doing so aggressively through this year and next. The bond market is already anticipating that. Prices are falling, which makes yields rise. But how should investors approach locking in some of those now higher yields while facing the possibility that prices could fall even further? To learn more about that, I reached out to Kathy Jones, the chief fixed income strategist at Charles Schwab.

One thing you can consider if you're really just wanting to be safe and secure but earn a little bit of yield, you can stay in shorter duration high-quality bonds like Treasuries or maybe, you know, highly rated investment-grade corporate or municipal bonds because the market's already sent the yields up for 2- and 3-year bonds pretty high in anticipation of those rate hikes. And so there's likely to be a lot less volatility if rates continue to rise from there. Longer-term bonds tend to be a lot more volatile. They're much more sensitive to changing interest rates. So, if rates continue to rise from here, then long-term bonds will, you know, underperform, assuming the yield curve doesn't continue to invert.

Assuming the yield curve doesn't continue to invert. Now, if you followed the financial news this past week, you might have heard a lot about something called yield curve inverting. That's not quite as complicated as it sounds. Let me see if I can simplify. If I plotted the yields on various maturities of Treasuries, starting at 1-month ones and going all the way to 30-year ones, and then I connected the dots, I'd have something called the yield curve. Under normal conditions, the yield curve rises because investors demand higher yields on long-term Treasuries than on short-term ones. That's because when they buy their bonds and lock in their yields, there's a thought in the back of their minds. What if economic growth from here is strong and interest rates rise? Then future bond buyers would be able to lock in higher yields. My bonds by then wouldn't look so good. They'd dip in price to bring their payouts up for future buyers, but not for me. Mine would already be locked in. My friends would probably laugh at me. They call me Mr. Small Yield or Professor Bought Too Soon. If I told my kids to do their homework, they'd roll their eyes at me and say, whatever, fixed income expert.

I don't think they go that low.

Thank you, Jackson, but they already sometimes call me dude. The point is, the longer the bonds investors buy, the more time there is for stuff like that to happen, with or without the name-calling. So investors should demand higher yields on longer bonds to compensate for that risk. Once in a while, however, part of the yield curve inverts. In other words, investors settle for lower yields on long bonds than they could get on short ones. Why would they do such a thing? Well, one reason is if they're confident that future economic growth is going to stink. In that case, they'd be willing to bet that interest rates aren't going to rise from here, and they'd be eager to lock in longer bonds today and not be so picky about yields. So basically, when the yield curve inverts, it makes some investors say, does the bond market know something that I don't? Is future economic growth going to stink? On Monday of this past week, the 5-year Treasury yield briefly pulled ahead of the 30-year one, which hadn't happened since 2006, which was followed by a big recession. Investors watched the difference between 2- and 10-year yields more closely, and that part of the curve briefly inverted on Tuesday. Over the past 40 years, the 2- and 10-year yields have been inverted only 7% of the time, according to Baird Private Wealth Management. Since 1978, those inversions have predicted 6 recessions with just 1 false positive. So you can see why investors might be worried. A recession, especially combined with today's inflation, could cause the stock market to tank. And an indicator that has been right about recessions in the past is starting to signal one now. But there are a few important caveats. Longer-term bond yields have been held artificially low by the Federal Reserve making big bond purchases, so the yield curve might be giving a false signal. The most accurate recession predictor historically has been the difference between 3-month and 10-year yields, and it's nowhere close to signaling a recession now. Also, yield curve inversions don't necessarily predict immediate recessions. The average stock return over the 12 months following an inversion has been 11%. Okay, so Kathy says we should keep an eye on the yield curve inversion I asked, for investors who remember much higher bond yields from earlier decades, should they lock in some bonds now or hold out for higher yields?

The demographics are such that we have aging populations in most of the developed world, and that typically means slower growth, lower inflation, and more demand for income. We have a lot of buyers around the globe looking for those yields, and that tends to kind of hold them down. So I don't think we're in a market that's going to take us back to those 5, 6%. But I do think we can get higher. It depends on whether we can get the economy growing at a little bit faster rate and keep the demand side going. So there's a possibility a year or two down the road we could be looking at 3% Treasuries or 3.5% Treasuries, which translates into, you know, maybe 4.5% corporate bond yields. Not a bad proposition. For an income investor.

Kathy says that investors shouldn't necessarily wait to buy bonds until the Fed has carried out all of its interest rate hikes because the market has already anticipated some of that. One thing that could matter a great deal for future yields is whether the Fed's actions will be enough to get inflation under control. She thinks they will.

I'm not sure they're as far behind as perhaps they believe. Right now, they're really talking aggressively about just hiking rates as fast as they can to get back to quote unquote neutral and to shrink the balance sheet, which is going to shrink liquidity. And I think that there's a risk that they overdo it if they move too fast.

So does it follow then that you think that a large portion of this inflation will kind of take care of itself as we go further into the year, maybe later this year?

I do think so, because, you know, A, the basic math of how it works should help, right? We have a compare year over year comparison. Now will start to be somewhat favorable. So that will help take the headline inflation down. At some point, supply catches up with demand or you destroy demand because prices are too high. At some point, if the price of gasoline is too high, people will cut back on their driving or they'll cut back elsewhere. So that will slow demand relative to supply. And given that inflation is kind of a supply-demand imbalance, I do think it will be better towards the end of the year with or without aggressive changes by the Fed.

I asked Kathy where she's seeing good deals in income investments, and she mentioned high-grade corporate bonds and preferred stocks. We'll say more about both of those in a moment after this quick break.

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Welcome back. Let's look more closely at the menu of choices available to income investors after this recent rise in rates. What we need is someone who shops in these markets for a living. Maybe a big portfolio manager who works across bond and stock markets.

Hi, my name's Michael Fredericks. I'm a portfolio manager at BlackRock where my team manages really 3 different income-oriented strategies. They're multi-asset, meaning that we invest across stocks as well as many different bond markets.

Well, that's handy. That's Michael Fredericks. And he's the head of income investing for the BlackRock Multi-Asset Strategies team. He says it's a good time for income investing. A year ago, decent yields were scarce. Suddenly there are better opportunities, and not just in treasuries.

You're at levels now on the high-yield bond market, on the index, as a yield over 6%, you know, and even surprisingly short-term investment-grade bonds last summer were yielding 0.5%. And now they're up to about 3. Then inflation adjusted, that's still a negative yield because inflation's running so hot at the moment. But that's still, you know, if you've got cash on the sidelines, it's a market that I think people should take a look at.

And I guess what we need to know is to adjust for inflation, you know, we have the number for the past year, we need to know the number for the coming year to really know what's that number gonna be? What do you think that is gonna happen with inflation? Over the course of the next year?

Well, I think some humility is in order because I can't remember a more uncertain time in my career on so many different dimensions. But frankly, I don't think anybody knows where inflation is going to be for the second half of the year, aside from it's probably going to decelerate.

The latest reading on inflation is 7.9%. It's likely to be lower in the year ahead as we lap last year's price spike, but How much lower depends on supply chains and the war in Ukraine and consumer demand. Michael says if you want to get a sense of how uncertain things are now, just look at Wall Street forecasts for, say, the 10-year Treasury yield by mid-2024. The highest estimate is 4.5%. The lowest is 1.7%. That's a big gap. The same goes for economic growth. The forecast suggests that in 2024, we'll either get 3% growth after inflation or a 1% contraction. That's like saying you'll either get a vanilla ice cream cone or run over by an ice cream cart. Michael says against that backdrop, this is no time to be heroic and make big bets. He's struck by how little the stock market has fallen relative to the bond market this year And remember, as bond prices have come down, yields have risen. From here, Michael says investment income could become more important.

Do you want to bet that prices are going up from here of your assets, or do you want some carry? And I, I think it may well be kind of a sideways price market for the balance of the year. And I think that makes income a lot more attractive.

Okay, let's talk about specific categories. Michael says that longer treasuries like the 10-year paying about 2.3% do not look that appealing right now. But that they might play a role for investors diversifying against risky assets. Michael finds short-term high-grade corporate bonds more appealing.

I mentioned earlier, you know, this idea of short-term investment-grade bonds yielding about 3%. Those are actually looking pretty attractive. And it's not just because the front end of the curve has moved up. It certainly has moved up a lot, but also the spreads on short-term investment-grade bonds have widened. So the spread that you get over Treasuries is a lot more attractive than it's been in a while.

Then there are high-yield bonds, sometimes called junk bonds because they're issued by companies with riskier credit ratings. They tend to perform well in a strong economy and poorly in a weak economy when not all companies can make good on their payments. But there's a huge range of quality in the junk bond universe. Some low-quality bonds pay more than 8%. Michael says those can be a roller coaster. He likes the slice of the market that's just below investment grade. In other words, the highest quality part of the junk market. In terms of ratings, those bonds are called BB, which yield around 5%, and BB, which yield a little over 6%.

Some of those names are expected to get upgraded to BB territory, and, and some of the BBs are expected to get upgraded into investment grade over the next couple years. We think about 15% of the high-yield universe is actually going to get upgraded.

If Michael's right about upgrades, prices for some of those bonds should rise. I asked about preferred stocks. Those aren't bonds, but they pay relatively high fixed incomes. Many are offered by banks whose balance sheets are generally strong now. Michael says he likes preferreds from high-quality banks that pay 4.5% to 5%. He says that many investors love preferred stocks but that they shouldn't overdo it because prices can sometimes be volatile. He is not keen right now on two categories with especially high yields called business development companies, or BDCs, and mortgage REITs, or real estate investment trusts that buy mortgage securities instead of properties. That's because both of these use a lot of leverage, which makes them too volatile for his tastes. He has invested in the past in master limited partnerships, which often own energy assets like pipelines and pass income on to investors as distributions. He says he made good money on MLPs in the early 2000s, but that he doesn't invest much in them now because their performance can be tied in part to the price of oil. Which is difficult to predict. There's a lot we're not getting to here— bond markets outside the U.S., for starters— but I want to mention two last things. Michael says regular stocks with high dividend yields are particularly attractive now. The S&P 500 has gotten more expensive relative to earnings over the past 5 years, but its high-dividend stocks on the whole have gotten cheaper. Much cheaper, in fact. Investors sometimes worry that high-dividend stocks will fall like bonds if interest rates rise, but Michael says they become less sensitive to interest rate changes over time, maybe because they include plenty of energy and defensive companies that appear well-positioned now. What has become more vulnerable to rising interest rates is the rest of the stock market because it's dominated by pricey growth stocks. Investors can buy high-yield stocks with an exchange-traded fund called SPDR Portfolio S&P 500 High Dividend. The ticker is SPYD. Also, Michael recommends something called covered call writing. That's an option strategy, and we'll have to look at it more closely another time. But basically, whereas some options purchases involve risky all-or-nothing bets on the direction of stocks, Covered call writing involves selling a bet to the risk-takers. Your risk is that you miss out on some of the upside if your stock rises a lot. Your reward is immediate cash in your pocket equal to the price of the bet. In a soaring stock market, you wouldn't want to be doing a lot of covered call writing because you'd limit your upside. But if you think the overall stock market could be flat for a while, it's a strategy to boost your portfolio income. And by the way, it takes a lot of money and math to properly diversify a portfolio of individual bonds. There are plenty of bond funds that play in all of the categories we just mentioned, or you can buy a multi-asset fund. The one Michael manages, if you're interested, is called BlackRock Multi-Asset Income. The ticker is BIICX if your broker offers the institutional shares. Thank you, Kathy and Michael and Ethan from Iowa. And thank all of you for listening. Jackson Cantrell is our producer. He says government savings bonds aren't just for grandparents anymore. He says all the cool kids are hanging out on—

what's the website, Jackson? TreasuryDirect.gov.

Hang on, let me write that down in my savings account passbook here. I just got to get some more ink on this feather. Subscribe to the podcast, write us a review on Apple, and you can follow me on Twitter. That's @JackHowe. H-O-U-G-H. See you next week.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.