After more than a decade as an afterthought—a portfolio component that offered mediocre returns alongside rising risks—bonds are once again part of smart investor conversations.
"All of the sudden, bonds matter again," said Scott Grauer, head of BOK Financial's® wealth management division. "With the return of stock market volatility, bonds offer a predictable, consistent, risk-adjusted income stream that makes a difference on your portfolio returns."
What's the impetus for the reemergence?
Elevated interest rates. As the U.S. Federal Reserve continues to push its key lending rate higher to combat inflation, the cost of borrowing has risen, which translates directly into higher yields on bonds and other fixed income investments.
"It's been an interesting shift where now the interest rate environment is an advantage for the saver, not the borrower," said Steve Wyett, chief investment strategist with BOK Financial. "If you've been out of bonds for a while, it's a good time to look at them. If you've been in them all along, it's a lot better environment than we've had for many years."
A refresher on bond investments
A bond resembles a loan: In exchange for cash, a bond issuer promises to pay interest on the funds until a specific date in the future, when it will repay the initial investment.
Bond variables include:
- The credit quality of the issuer. More stable issuers offer lower rates than riskier issuers.
- The duration of the bond. Issues with longer-term maturity (or end dates) usually carry higher rates than those that mature within two years.
- The investment environment. Although the U.S. Treasury market broadly drives interest rate levels, company, industry or geographic variations may influence the yield on a specific bond.
"With some work, advice and analysis, anyone can find the right fixed-income investment for their portfolio, given their risk tolerance and their time frame to invest," Grauer said.
"Ultimately, the maturity date and value of the bond provides predictability of return because in a worst-case scenario, if you hold a bond until it's due, you know what you're getting back."
That kind of predictability has long supported the roles of bonds as an effective counterbalance to stocks.
“We’ve historically looked at bonds as not a way to get rich, but a way to stay rich.”- Steve Wyett, chief investment strategist
"If people want to take 4%, 5% or 6% out of their portfolio every year and they're able to build a bond portfolio that funds that distribution of money, they don't have to sell something to fund it and reduce their principal," Wyett said.
In addition, Grauer noted that municipal bonds, which are issued by city, county and state entities, provide an extra tax benefit as interest payments are exempt from federal income taxes and may be exempt from local or state income taxes.
Therefore, a municipal bond with a 4% interest rate generates the same after-tax cash flow as a corporate bond paying 5% to 7%, after accounting for the bondholder's full income tax burden. As a bonus, municipal bonds tend to be high-quality issues with lower risk profiles.
"Municipal bonds help people manage their overall taxable income, keep within a tax bracket or simply keep more of what they earn on their investments," Grauer said. "They were less appealing when rates were at historical lows, when the taxable equivalent to a municipal bond paying 1% was around 1.2%. That difference doesn't get people very motivated.
"But when we're talking about the taxable equivalent of a 4% municipal bond being around 6%, investors appreciate the after-tax benefits."
Example of municipal bond vs. taxable bond
|4% Municipal Bond
|6% Taxable Bond
|Annual interest paid
|$2,000 federal and state taxes (assuming 28% federal tax rate + 7% state tax rate)
|Net annual interest earned
2022 a turning point
Fractional differences between corporate and municipal bonds initially surfaced during the 2008-2009 Global Financial Crisis, when the U.S. Federal Reserve slashed its key interest rate to near zero to help ease the financial market chaos.
In addition to lowering borrowing costs, the moves boosted the value of bonds, which go up as rates go down (and vice versa). Once that crisis passed, rates gradually moved modestly higher, but remained considerably lower than 2007 levels, until the pandemic prompted a return to near-zero rates in 2020.
"Bonds have always been a part of our process. When rates are lower, the investor may rely on the value of the bond rising to make up for the small yields," Wyett said. "However, when rates increased as dramatically as they did last year, the drop in bond values was extremely painful."
As part of its fight against rampant inflation in 2022, the Fed hiked its key lending rate to more than 4% from essentially 0%, resulting in double-digit losses across much of the bond universe. Declines on some bonds even exceeded losses in stock values, especially among long-term issues, which are more sensitive to interest rate swings.
"That was the most significant and immediate reversal of the rate environment that we've seen, and it caused massive amounts of uncertainty and volatility," Grauer said. "Having come through that, however, we believe it brought the return of real value in the fixed income sector, whether we're talking about Treasury, corporate or municipal bonds."
The information provided is intended to be educational in nature and not advice relative to any investment or portfolio offered through any subsidiary of BOK Financial Corporation (BOKF), a financial services holding company (NASDAQ:BOKF). The views expressed reflect the opinion of the authors based on data available as of the date published and are subject to change without notice. These statements are not a complete analysis of any sector, industry or security. Individual investors should consult with their financial advisor before implementing changes in their portfolio based on opinions expressed. The information provided is not a solicitation for the investment management services of any Investment subsidiary.