Bonds, especially long-term bonds, have taken headline hits recently. Last month it was the Moody’s credit rating downgrade, recently it was President Trump’s sweeping tax bill. Major outlets from Bloomberg to The New York Times have published stories that could lead many investors to steer away from long-term bonds.
In my opinion, investors looking to maximize the income generated from their portfolios should consider longer-term bonds right now. In this case, I’m referring to 10-year bonds or longer. These bonds now offer attractive yield advantages over shorter-term bonds and can also help to increase portfolio diversification, potentially acting as a hedge against negative returns in equity markets. Investors should consider long-term bonds as part of their diversified investment portfolio.
Recent History of Bonds
From the aftermath of the great financial crisis in 2008 through the end of the COVID-19 crisis in 2020, global interest rates were repressed by central bankers seeking to stimulate economies. This was good for risk assets such as equities, but not good for those investors who relied on the income generated from their bond portfolio.
As an example of how far interest rates fell, the yield on the benchmark 10-year U.S. Treasury bond reached an all-time low of 0.65% in June 2020 during the peak of the pandemic. But as interest rates have risen, yields in many bond sectors are now well above their five-year averages and present an attractive investment opportunity.
Why Should Investors Consider Long-Term Bonds Over Short-Term Bonds?
When weighing the relative value between short-term and long-term bonds, one must consider whether the additional yield is worth the additional risk. For a majority of the past five years, the yield differences between longer-term bonds and shorter-term bonds were negative—investors were not being compensated for taking on the additional maturity risk. But as the Federal Reserve began to increase policy rates to combat the post-pandemic rise in inflation, longer-term yields began to increase more than shorter-term bonds, “steepening the yield curve.” The additional yield now offered by “moving out on the curve” is the highest it has been since the summer of 2022.
Using U.S Treasuries as an example, the additional yield pickup from a 2-year to a 10-year bond is 0.45%. For high-quality, tax-exempt municipal bonds and corporate bonds, the additional yield is higher at 0.67% and 0.79% for AA-rated municipal and corporate bonds, respectively. For those investors willing to take on more credit risk in A-rated and/or BBB-rated bonds, the additional yield is even higher.
The current yield pickup for municipal bonds is notable as these yields are closer to the highs of the last five years than either Treasuries or corporate bonds.
Can Long-Term Bonds Be Used To Hedge Equity Volatility?
When markets faced significant disruptions in the past during the great financial crisis, the European sovereign debt crisis, COVID-19 and the Silicon Valley Bank collapse, long-dated bonds, and specifically U.S. Treasuries, performed well as investors sought the safety and security of the U.S. dollar and the U.S. Treasury market.
During these crises, long-maturity Treasuries acted as a hedge against the negative returns in equity and other markets. However, when the Fed began to move interest rates higher during the 1970s oil crisis and after COVID-19, bond returns were negative, along with riskier assets. The hedging effectiveness of long-maturity Treasury bonds only works when the factors contributing to the dislocation are not caused by, or exacerbate, an increase in inflation.
A crisis causing a slowdown in nominal growth will force central banks to reduce interest rates, and as a result, lower yields mean higher bond prices. However, a crisis causing inflation to rise may result in central banks increasing interest rates, causing bond prices to decline.
What Are The Current Effects Of Inflation On Long-Term Bonds?
Owning longer-term bonds increases interest rate risk. The price of a long-term bond is more susceptible to changes in interest rates than a short-term bond. If interest rates increase, then the price of a longer-term bond will decline more than the price of a shorter-term bond. The most significant risk in longer-term bonds is an unexpected increase in interest rates. The primary driver of higher interest rates is an acceleration in inflation or expected inflation.
Despite the recent uncertainty around tariff implementation, market-derived inflation expectations have remained well contained. As of June 15, the 5-year inflation expectation derived from the TIPS (Treasury Inflation Protected Security) market was 2.3% and has been declining since its near-term peak of 2.7% in February. Essentially, expected inflation isn’t so bad right now, which should offer some comfort to investors.
With the recent rise in longer-term nominal interest rates over the last few months, combined with the decline in inflation expectations, the expected real yield on longer-term bonds has increased. The real yield is the net yield of a bond after accounting for expected inflation.
For a 10-year Treasury, the real expected yield, as reflected in the current TIPS market, was 2.10% as of June 13, which is 0.60% more than that of the 2-year Treasury. The 10-year real yield is near its highs of the last 20 years.
Why Long-Term Bonds Are More Strategic Than Money Market Funds Today
For those investors focused on maximizing income, investing in higher, longer-term yields can be an advantage should interest rates decline—investors in very short-term money market funds should take heed.
By year-end, economists and market participants expect the Fed to reduce its policy rate by 0.50%. According to the Investment Company Institute, there is over $7.0 trillion currently invested in money market funds. The median money market fund yield is 4.38% as of April 30, according to the Office of Financial Research.
Money market fund rates are highly correlated to the fed funds rate. If the fed funds rate is reduced by 0.50% by the end of the year, then one would expect the yield on money market funds to decline by at least that amount, pushing the median yield below 4%.
In comparison, the current 10-year Treasury yield is 4.4% and the average 10-year AA-rated corporate bond yields 4.96%. The average 10-year AA-rated municipal bond yields 3.62%, which, adjusted for the maximum federal tax and surcharge, is a tax-equivalent yield of 6.11%.
Which Long-Term Bond Sectors Look Attractive?
For investors who wish to maximize their after-tax income and are in a high income-tax bracket, municipal bonds offer very attractive tax-equivalent yields in comparison to Treasury or corporate bonds.
For those investing in tax-deferred accounts or whose tax rate is considerably lower, the additional yield from corporate bonds over U.S. Treasuries looks attractive. As always, investors should consult with their tax advisor and investment professional before investing.
How To Add Long-Term Bonds To A Portfolio
Longer-maturity bonds can be implemented in portfolios by purchasing individual bonds, or specific ETFs or mutual funds that target long-maturity bonds. There are advantages and disadvantages to each.
For investors with sufficient assets, I recommend owning individual bonds in a professionally managed portfolio. This allows for more customized implementation and reduces the risk of unplanned tax consequences that may occur in mutual funds.
Implementation through mutual funds and ETFs can be useful for smaller investment amounts and those looking for a higher level of liquidity. Bond ETFs are traded throughout the day, while mutual funds are priced at the close of each day.
The Bottom Line: Don’t Fear Long-Term Bonds
Investors should not be afraid of investing in long-term bonds as part of a diversified portfolio. Current yield levels on both a nominal and real (after-tax) basis are appealing when compared to previous years. There are, however, risks to owning these bonds. An increase in yields due to inflation or other means can cause bond prices to decline. The longer the bond term, the more the price will be impacted. As part of a well-diversified portfolio, the inclusion of long bonds has the potential to increase investment income and returns.
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