Do Bonds Deserve Your Attention in 2023? Investors Should Know

Consistent returns in the markets are hard to come by. Equity markets in particular have seen tremendous headwinds in the face of 40-year high inflation. However, debt-based securities such as bonds can soften volatility. A bond is a debt security issued by corporations and governments that are sold to investors. The primary reason for issuing bonds to the public market is to raise capital. Both governments and corporations can utilize this inflow of capital towards large projects that require substantial investment.

Generally, government bonds are seen as safer. Where there is more certainty, there is also less to gain. Due to the risk of default, corporate bonds tend to offer higher interest rates than governments. Bonds have become favorable due to poor performance in equity markets in 2022.

How do Bonds Work?

For the sake of simplicity, we will focus on the 10-year treasury note. This is one of the most common bonds, offered by the United States government. The 10-year US treasury was yielding 3.7% to start 2023 in comparison to 0.6% in mid-2020. Like many other bonds, the face value of the bond, also known as the nominal value, is scheduled/agreed to be paid at the date of maturity. Up until that date, holders of the note will receive fixed interest payments every six months. Because of its popularity, it is often used as the benchmark for other forms of debt securities. Equity markets also tend to peer towards bonds as the yields climb. This is simply because bonds are often viewed as risk-averse in comparison to stocks.

While a rising yield is certainly more appealing, there remains the risk that bondholders will lose out on higher yields in the future. Similarly to stocks, the fear of missing out remains the same. Bonds that were purchased at a higher yield are now more desirable in comparison to those that weren't. To draw a comparison, this is similar to dividend stocks. As the stock declines, the dividend yield tends to increase. As a result, the rewards for shareholders, or in this case bondholders, are generally greater.

A rise in yield can be attributed to a couple of factors. Interest rates are the primary example, but a rise in the credit risk of the bond issuer can also increase the yield. Investors need more of a reward to compensate for higher risk. The 10-year note doesn't harbor this quality concern since it's offered by the United States government, but many bonds offered by corporations do.

Historical Returns

As much as we'd like to praise bonds for their stability, the returns aren't comparable to stocks over the long term.

The S&P 500 has averaged 11.8% per year since its inception. This data includes depressions, recessions, and other economic headwinds. Bonds on the other hand have varied dramatically in performance. Yields in the early 1980s were a staggering 15%, but have since shrunk. Bonds haven't seen such performance in decades due to suppression in borrowing costs from central banks. As a result, governments and corporations, until recently, were able to borrow cheap debt.

Since stocks have generally outperformed in most decades, why do investors continue to invest in bonds? The answer is simple; the future is not predictable. Historical results are important to note, but not necessarily the whole picture. The risk-reward between stocks and bonds is vastly different. Despite stocks historical outperformance over the long term, they are susceptible to incredible volatility and unpredictability in the short term, whereas bonds are less susceptible.

Bond Characteristics

Generally speaking, bonds are seen as risk-averse in comparison to other asset classes due to the predictability and consistency of payments. However, losses are possible. As mentioned, as interest rates climb and the borrowing rates for newly issued bonds rise, current bondholders are left holding a less appealing asset. The future payments are less attractive in comparison to higher bond yields being issued.

Firstly, bonds can provide consistent income. The yield of the 10-year not has been 3.7%. Other bonds, some of which are offered by corporations, may offer higher or lower yields depending on their risk profile. Generally, investors should anticipate a higher yield from corporations, otherwise, there wouldn't be much of an incentive in contrast to the 10-year note.

Secondly, offsetting investment volatility. Allocating a sizable amount toward bonds can reduce the total volatility of an investor's portfolio value. While they may not receive the full benefits of a ‘bull run' when markets are optimistic, they also won't experience devastating losses in a downturn. Additionally, the income from bonds can be used to fund other investments, including stocks or real estate. Using the capital generated from a bond, an investor can build a portfolio without using as much of their hard-earned income.

Closing Thoughts

The past couple of decades have seen lackluster enthusiasm for bonds, but that could be changing. As central banks raise the costs of borrowing, governments and corporations will need to look for alternative options to raise capital. To incentivize inflows, they'll need to compete for investors' attention with an equally—or in some cases higher—bond yield. Given macroeconomic headwinds, it makes sense for investors to lean towards bonds, such as the 10-year note, to hedge against uncertainty.

With rising bond yields, there is now a compelling alternative to generate income in a portfolio as opposed to just stocks. However, there is still a chance that bond yields will continue to appreciate in the near term if borrowing costs continue to rise. While stocks have historically outperformed over multiple decades, bonds are still a compelling investment vehicle worth considering.

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