How to Build a Bond Portfolio (2024)

Bonds are back! That's been our theme recently as we highlight the attractive yields that many bond investments offer.

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?"

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.

The bond market is large and complex, with different types of bonds with varying degrees of risk. It can be difficult to know where to even start.

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.

Indexes representing the investment types are: U.S. Treasuries = Bloomberg U.S. Treasury Index; Mortgage-Backed Securities = Bloomberg MBS Index; U.S. Aggregate Bond Index = Bloomberg U.S. Aggregate Bond Index; Municipal Bonds = U.S. Municipal Bond Index; Investment Grade Corporate Bonds = Bloomberg U.S. Corporate Bond Index; Preferred Securities = ICE BofA Fixed Rate Preferred Securities Index; Bank Loans = Morningstar LSTA Leveraged Loan 100 Index; High-Yield Corporate Bonds = Bloomberg U.S. Corporate High-Yield Bond Index.

Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated. Correlations shown represent an equal-weighted average of the correlations of each asset class with the S&P 500 during the 10-year period between January 2012 through December 2022. Diversification strategies do not ensure a profit and do not protect against losses in declining markets. Past performance is no guarantee of future results.

* Suggested allocation range as a percent of the overall portfolio.
** Agency mortgage-backed securities includes Ginnie Mae, Fannie Mae, and Freddie Mac mortgage-backed securities.
*** We suggest the total of all aggressive income investments constitute no more than 20% of an investor’s overall portfolio unless the investor's objective is for high income with a high tolerance for risk.

For illustrative purposes only.

The higher yields that aggressive income investments offer may be tempting, but they come with more volatility and larger potential drawdowns. The chart below compares the average annualized total returns with the average annualized standard deviation (a measure of risk) between many fixed income asset classes. The Y axis represents the annualized total returns—the higher the dot, the higher the average return. But it also shows that higher returns tend to come with more risk, as the X axis illustrates. A higher standard deviation means more volatility, so investors reaching for higher-yielding investments need to be ready to ride out the ups and downs.

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.

Despite the recent decline in yields, we continue to suggest investors gradually extend duration—meaning investing in bonds with more intermediate- or long-term maturities—rather than waiting in cash or other short-term investments for yields to rise more. Although the 10-year Treasury yield is below its recent peak, it's still at the high end of the post-financial-crisis trading range. Aside from the recent readings, the 10-year yield hadn't touched 3.5% since 2011.

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.

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.

The fixed income landscape is attractive today. After a disappointing 2022, the starting point for yields is significantly higher than it was last year, and with the Fed nearing the end of its rate hike cycle, high-quality bond prices are less at risk of sharp declines. We prefer high-quality fixed income investments, like the "core" bond segments mentioned above. With a gloomy economic outlook, we're cautious on the riskier parts of the market. There may be better entry points down the road to consider larger positions of lower-rated bonds, but until then a more cautious approach is warranted.

There are number of ways to invest in bonds: individual bonds, mutual funds, exchange-traded funds (ETFs), or separately managed accounts. There are benefits and drawbacks of each approach, and it ultimately comes down to investor preferences.

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.