Bonds: A Wise Choice for a Diversified Portfolio

Tyler Kert
Tamarack Wealth Management

When interest rates go up, bond prices go down. I still remember my finance professor hammering that concept into my brain through endless repetition. Now, looking back, it makes more sense because I’ve watched this concept play out in the real world. Just a few short years ago, it wasn’t unheard of for mortgage lenders to offer rates as low as 2.5% or less. They were able to offer such low rates because the Federal Reserve had cut rates to historic lows. In fact, for most of the past 15 years, interest rates have hovered near historical lows. However, as the economy recovered from the pandemic, inflation also picked up steam. According to the Department of Labor data, inflation had soared to 8.5% by March of 2022. In an effort to slow the high inflation, the Fed raised interest rates drastically and these rate increases sent bond prices reeling. An article published February 9th, 2023, by Forbes was titled, “The Worst Bond Year Ever Was 2022 – What Does That Mean For You?”. Clearly, the bond market did not respond favorably to the drastic rate hikes. 

However, since then, the Federal Reserve has been hinting that rates aren’t going to stay high forever. These hints, paired with the current discounted price, make bonds a promising option for investors looking to lock in attractive yields for the long term.

Investors should always understand what they are investing in. So really quick, let’s step back and make sure that you have an understanding of what an investment in bonds entails. As an investor in bonds, you are a lender. Investing in bonds means lending money to a government, corporation, or other entity for a fixed period of time. In return, the borrower (government or corporation) promises to pay back the principal amount on a specific date (maturity date) and to make periodic interest payments to you, the bondholder.

Now, as with every investment, there are risks involved. For example, you run the risk that the entity that you loan money to goes bankrupt and can’t pay you back. However, you can mitigate this risk by being careful who you loan money to. Loaning to the U.S. Government is considered the gold standard of bond investing because, to date, they haven’t defaulted on their debt. Now, the seemingly out-of-control national debt is starting to raise questions, but that is another conversation. Generally speaking, bonds are a safer, more stable investment than investing in stocks. Therefore, they have been historically considered a foundational piece of a diversified portfolio. 

Since bond prices plummeted to new lows by the end of 2022, prices have stayed relatively constant. As a result, you could consider bond prices to be “on-sale”. If you’re looking to buy low, now would be a good time. In addition to the current prices being on sale, the outlook for bonds shows promise because of the Federal Reserve’s goal to start lowering rates. Again, bond prices and interest rates are inversely correlated. As inflation cools and rates start to come down, bond prices will go up.

Many investors are taking full advantage of the short-term yields available at banks and financial institutions right now. If I had a dollar for every person who’s told me how happy they are to be making 5% in their “risk-free” bank account, I’d be making a lot more than 5%. But these short-term returns won’t last forever. Inevitably, 5% money market yields will start to come down.

Finally, diversifying into bonds may not be the right choice for every investor. Bonds may not make sense for those investors that have a high risk tolerance and a lot of time to recover from potential market downturns. Ultimately, your financial plan that encompasses your individual goals and timeframe should determine your asset allocation and the makeup of your investments. But if you have a significant amount of money socked away, earning 5% in a money market account, you should consider diversifying into bonds and taking advantage of the higher yields that are being offered in this high-rate environment. If you wait until your money market fund is only paying 3% instead of 5% and no longer outpacing inflation, you’ll likely miss the window to lock in a higher yield on a long-term bond portfolio. At the very least, take some time to review your financial goals and priorities. If you’re unsure whether you’re making the best financial decisions for your individual situation, you need a financial plan. A plan can ensure that you achieve your long-term financial goals, limit the taxes you pay, and ultimately prepare you for whatever the future has in store.

Tyler Kert, a licensed financial advisor and CPA, provides financial planning and tax consulting services at Tamarack Wealth Management in Cashmere, WA.