Reinvestment Risk of Short-Term Bonds
The Federal Reserve's aggressive interest rate hikes helped push yields on shorter-term bonds to their highest levels in more than 20 years. But with rates generally thought to be in retreat, investors could see their income decline as they struggle to replace their current rate of return.
"As interest rates come down, people holding short-term investments will likely have to reinvest the proceeds from their maturing securities into those with lower yields," says Collin Martin, CFA®, a director and fixed income strategist at the Schwab Center for Financial Research. "So, if you shifted into short-term vehicles like Treasury bills over the past few years, you might want to start looking for opportunities to gradually increase your intermediate-term holdings as rates continue to fall."
That said, why would you want to invest in, say, a 10-year Treasury bond yielding close to 4% when T-bills with very short maturities were still yielding near 5% as of late August?
If yield were your only consideration, you might not. "Yields on some intermediate-term bonds dipped this summer, making them less attractive than they were in the spring," Collin says. "However, the outlook for intermediate-term bonds remains positive, and some are still offering attractive yields if you're willing to tolerate a little extra risk." Investment-grade corporate bonds in the 5- to 10-year range, for example, are only slightly riskier than T-bills and were yielding between 4.5% and 5% in late August.1 "So, not only would you be getting similar yields, but also you'd be locking them in for longer," Collin says.
Another option is to build a bond ladder. "With a five-year bond ladder, for example, you would have one or more bonds maturing each year over the next five years, giving you an opportunity to reinvest gradually versus all at once," Collin says. "That way, you can continue to capture today's relatively high rates for as long as they last, while also hedging against their anticipated decline."
Locking in today's higher yields offers another benefit: It makes you less reliant on stock returns. "For years the bond market offered paltry yields, causing many fixed income investors to stray into riskier areas of the market," Collin explains. "But now that you can get intermediate- or longer-term bonds with yields near 4.5% or more, you may not have to take on as much risk to reach your goals."
- Research investment-grade corporate bonds.
- Learn more about building a bond ladder.
1Bloomberg Investment Grade Corporate Bond Yield Curve, as of 08/26/2024.
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