One of the most common questions I get from clients is:
After a few years of very mediocre bond index performance, investors may finally earn meaningful income from bonds. But will these higher yields last?
This week, the U.S. Treasury announced that it will increase its purchases of longer-term Treasury securities through its existing buyback program. The market reacted quickly: bond prices rose and longer-term Treasury yields fell.
While this doesn’t mean interest rates are suddenly headed straight down, it raises an important question for investors: If you want to lock in attractive yields, should you be doing it now?
Falling Yields: Good or Bad?
It depends on which side of the transaction you’re on.
If you already own bonds, falling interest rates are generally good news. Bond prices and yields move in opposite directions. When new bonds offer lower yields, existing bonds paying higher rates become more valuable.
But if you’re shopping for bonds today, you may actually want yields to stay high. A bond yielding 5% is more attractive as an income investment than the same bond yielding 4%.
That’s why waiting for rates to go even higher carries its own risk: today’s attractive yields may not be available later.
Individual Bonds vs. Bond Funds
This distinction is especially important because many investors don’t own individual bonds — they own bond mutual funds or ETFs.
With an individual bond, you know the maturity date and generally know the interest you’ll receive. Assuming the issuer doesn’t default and the bond isn’t called early; you can hold it through market fluctuations and receive the face value at maturity.
The bond’s market value will still fluctuate. If rates rise, your bond may temporarily be worth less. But if you don’t need to sell it, those price swings may not matter much to you.
A bond fund works differently.
The fund owns a constantly changing portfolio of bonds and has no maturity date of its own. When interest rates rose sharply over the past several years, many bond funds declined significantly in value. Investors continued receiving income, but the supposedly “safe” part of their portfolio often produced disappointing total returns.
Higher rates eventually help bond funds because maturing bonds can be replaced with newer, higher-yielding securities. But investors have to live through the price decline first.
Now the opposite can happen. If yields decline, existing bonds inside the fund become more valuable, potentially increasing the fund’s share price. Over time, however, the fund will begin reinvesting at those lower yields.
Bond funds still offer important advantages, particularly diversification, liquidity and ease of management. Individual bonds can offer something different: predictable income and a defined maturity date.
For investors who want specific amounts of money available at specific future dates, an individual bond or bond ladder may sometimes be a better fit than a traditional bond fund.
What About California Municipal Bonds?
California municipal bonds can be particularly attractive for higher-income California residents because interest from qualifying California municipal bonds is generally exempt from both federal and California state income taxes.
The Treasury isn’t buying California municipal bonds under this program. However, Treasury yields are an important benchmark throughout the bond market, so a sustained decline in Treasury yields can also put downward pressure on yields available on newly purchased municipal bonds.
Again, there’s a tradeoff.
If you already own a higher-yielding California municipal bond, falling market yields can increase its value. If you’re hoping to purchase new Munis for tax-free income, falling yields may mean the attractive rates available today become harder to find.
When evaluating municipal bonds, it’s also important to compare their tax-equivalent yield, rather than simply comparing the stated yield with a taxable bond or CD. For investors in higher federal and California tax brackets, a seemingly lower municipal yield can potentially provide more after-tax income than a higher taxable yield.
Credit quality and call provisions also matter, so not every municipal bond is appropriate simply because the income is tax-exempt.
What About CDs and Money Markets?
The Treasury’s bond-buyback announcement has much less direct impact on CDs and money-market funds because those yields are influenced primarily by short-term interest rates and Federal Reserve policy.
The Federal Reserve meets again September 15–16, and current market expectations favor the Fed holding short-term rates steady, although another rate increase remains a meaningful possibility. A rate cut currently appears much less likely.
This means we could see an interesting split: longer-term bond yields could decline while CD and money-market rates remain relatively attractive — or even increase if the Fed raises rates.
The important difference is that money-market yields can change quickly as short-term rates change, while a CD allows investors to lock in today’s rate for a defined period. For investors who don’t need immediate access to all of their cash, this can make a CD ladder worth considering rather than leaving everything in a money-market fund while waiting to see what the Fed does next.
The Bottom Line
There is no single “best” fixed-income investment.
Money markets offer liquidity. CDs offer a known rate and maturity. Individual bonds can provide predictable income and defined maturity dates. Bond funds provide diversification and liquidity but don’t have a maturity date. California municipal bonds may offer particularly attractive after-tax income for higher-income California investors.
And while no one knows exactly where interest rates go from here, this week’s Treasury action is a good reminder that today’s higher yields aren’t guaranteed to last.
Questions about your investment portfolio’s fixed income holdings?
We’d be happy to review your portfolio and help develop an efficient strategy for your fixed income holdings.
You can schedule a strategy session to talk about your unique situation and how we might be able to help. If you are a current client, contact us for a personal review of your situation at info@astifinancial.com.