With 10-year Treasury yields hitting multidecade highs, many investors are looking to incorporate more fixed income into their portfolios by shifting cash into two-year Treasurys, building ladders of Treasury Inflation-Protected Securities, and purchasing target-maturity bond funds. While bonds offer reliable income, safety, and portfolio diversification, wading into the market also introduces a unique set of risks that require careful consideration.
One common pitfall for novice buyers is chasing high yields simply for the sake of higher returns without evaluating credit risk. Buying a bond essentially means lending money to an issuer that promises to pay interest and return the principal upon maturity. Lower credit quality generally translates to higher yields due to an increased risk of default. Financial professionals warn that some investors mistakenly load up on high-yield junk bonds simply because they are enticed by the larger payouts, overlooking the reality that even iconic, large companies can occasionally fail.
Investors must also weigh duration risk, which dictates how long money is lent and exposes the portfolio to interest rate fluctuations. When interest rates rise, the market value of existing bonds and bond funds can decline, with longer durations suffering greater price drops. For individual bonds, investors can often ignore interim price volatility if they intend to hold the asset until maturity. To mitigate duration risk, investors who rely on bonds for steady income or anticipate needing to sell early can focus on short-term and intermediate-term holdings, or adopt a ladder strategy utilizing staggered maturity dates.
Call risk is another factor, particularly with many corporate and municipal bonds that include provisions allowing issuers to refinance their debt if market interest rates decline. If a bond is called, the issuer returns the principal along with accumulated interest, preventing the investor from maintaining the higher rate. Opting for noncallable bonds or searching for securities featuring call protection or a lockout period can eliminate this risk, though it may require accepting a lower yield.
Mortgage-backed securities introduce prepayment risk, where declining interest rates prompt homeowners to refinance their mortgages. This causes the underlying bonds to pay off faster than anticipated, cutting short the expected interest collection. Additionally, location matters significantly when it comes to tax risks. Bond interest is typically taxed at ordinary income rates, making tax-deferred retirement accounts like IRAs or 401k plans an efficient way to defer short-term tax hits. While municipal bond interest is generally exempt from federal income taxes, and Treasurys are free from state and local taxes, holding TIPS in taxable accounts can generate phantom income that requires cash to cover annual inflation-adjusted taxes.
Ultimately, financial experts emphasize that avoiding bonds entirely and leaving cash in low-yielding checking or legacy bank accounts may represent one of the greatest risks to long-term wealth preservation.