How bonds could play a key role in a balanced investment portfolio

A bridge crosses over a waterway

What do investors need to know about bonds now? A Wells Fargo Investment Institute strategist shares top considerations.

In 2022, rising interest rates have resulted in volatile bond markets, leading some investors to question the traditional role of bonds as an alternative to equities. Nonetheless, they can still play an important role in maintaining a balanced investment portfolio, says Brian Rehling, head of global fixed-income strategy for Wells Fargo Investment Institute. As you get closer to retirement, bonds could also offer a reliable stream of income, he says, that’s typically lower risk.

It may seem counter-intuitive to invest in bonds in a rising rate environment, but there are reasons to consider bonds for your portfolio.

Bonds can help offset volatility

Bonds still have a role to play to help counter the potential risks associated with investing in equities and other more volatile assets, Rehling says.

“For the most part, if you hold bonds to maturity, and you buy a quality issuer you should get your money back and you know exactly what you’re likely to get and when,” says Rehling. “That’s not true on the equity side.”

With bonds, you’ll typically receive interest payments a couple times per year. That’s fixed income you may count on, whereas you may not know what your returns could be with more volatile investments.

Generally, a healthy portfolio is a diverse portfolio. Even more aggressive investors can benefit from some diversification into bonds so that an entire portfolio isn’t concentrated in riskier positions.

Review various income-generating strategies

Rehling suggests exploring investment strategies for bonds that can help generate income, including a “bond ladder.” The ladder is a portfolio of fixed-income securities with each one having a different maturity date. This approach lets you plan or adjust your cash flow based on expected yields and your financial situation at any given time. It’s a strategy designed to provide income while helping reduce exposure to changes in the interest rate.

“The bond ladder can be an effective strategy for retirees because they should receive cash flows each year to cover expenses without having to worry too much about changes in interest rates,” Rehling says.

Consider strategies to help increase and lock in your yield

In the past five Federal Reserve (Fed) tightening cycles since 1990, U.S. Treasury yields have peaked before the end of the tightening cycle but did not begin a clear declining trend until the tightening cycle was over. Although the current Fed tightening cycle is still not over, we believe long-term rates are close to reaching their cycle peaks. While they may have not yet peaked, we view this as an attractive entry point over our tactical time frame (6 to 18 months).

While it is always difficult to call the top or the bottom in markets, there are signs that the economy could begin to weaken, while at the same time inflation starts to trend lower. With this in mind, investors may want to consider locking in a portion of their fixed-income portfolio at current yield levels.

As inflation begins to move lower next year, we may see rates move lower as well. Rehling offers additional perspective from Wells Fargo Investment Institute: “Shorter maturity products like certificates of deposit or floating-rate debt may help generate income, but investors may also want to consider locking in these rates for longer periods of time by buying longer maturities as well.”

For investors in higher tax brackets, municipal bonds have relative low levels of defaults, positive technical trends due to the supply-demand imbalance, and improved fiscal positions after the pandemic. For investors seeking yield, maintaining a neutral allocation in preferred stock and emerging market bonds may be one course to follow, but it is important to review opportunities with your advisor before making adjustments.

According to Rehling, bond investors will want to keep an eye on how things evolve in the months ahead: “Be sure to review portfolio holdings with your advisor and consider liquidity and risk tolerance needs as the market fluctuates.”

Revisit your plan regularly

No matter your goals, it’s a good idea to evaluate your bond strategy with a financial advisor. It can be part of a regular checkup of your investment portfolio, which can help make sure your allocations align with your investment plan. This also provides the chance to review your risk tolerance with your advisor to see if anything has changed — and if your allocations need to adjust as a result.

“It’s a chance to discuss how the bond allocation is performing in your portfolio and make sure you’re well-diversified within that allocation,” Rehling says.

 

Wells Fargo Investment Institute, Inc., is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was provided by Wells Fargo Investment Institute (WFII). Opinions represent WFII’s opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. WFII does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability or best interest analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. The material contained herein has been prepared from sources and data we believe to be reliable but we make no guarantee to its accuracy or completeness.

Investments in fixed-income securities are subject to market, interest rate, credit, and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can cause a bond’s price to fall. Credit risk is the risk that an issuer will default on payments of interest and/or principal. This risk is heightened in lower rated bonds. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.

Bond laddering does not assure a profit or protect against loss in a declining market.

Asset allocation and diversification are investment methods used to help manage risk. They do not guarantee investment returns or eliminate risk of loss including in a declining market.

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

There are special risks associated with investing in preferred securities. Preferred securities generally offer no voting rights with respect to the issuer. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer’s capital structure, subjecting them to a greater risk of non-payment than more senior securities. In addition, the issue may be callable which may negatively impact the return of the security. Preferred dividends are not guaranteed and are subject to deferral or elimination.