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Bond diversification vs. yield: Understanding the trade-off in portfolio construction remains as important as ever

Bonds were never gone, but the most favorable yield environment in over a decade has renewed investors’ attention in the asset class. Still, a focus on yield alone may subject an investor to avoidable risk.

Yields on high-quality bonds have risen sharply chart illustration“Bonds are back” has become an increasingly common phrase in recent months. We would argue that they were never gone, but coming off of last year’s challenging environment for high-quality fixed income, there’s good news for bond investors.

As shown in the chart above, bond yields have risen dramatically, largely in response to the Fed’s aggressive rate hikes that have lifted short-term rates by more than 4% in about a year. Consequently, the return outlook for fixed income is now much more attractive than it has been in over a decade. In fact, with yields close to 4% or better across the curve, the return outlook for Treasuries is now better than it’s been since before the 2008 global financial crisis pushed the Fed and other global central banks to slash rates and introduce quantitative easing to lift the global economy out of the crisis.

While it’s likely that short-term yields could see some additional upside in the near term, longer-term returns on high-quality fixed income are primarily driven by the yield to maturity of a bond or a bond portfolio. Additionally, as we discussed in a previous piece, higher fixed income yields provide a greater buffer against the negative price impact of further upside in interest rates.

High-yield bonds have also seen a notable rise in yields to over 8%, increasing their potential attractiveness for many investors. But that incremental income comes with a price: these bonds are highly correlated to equities, limiting their attractiveness as an equity diversifier and subjecting them to additional downside risk if equity volatility reemerges.

For now, investors can clip an attractive yield from high-quality bonds, while benefiting from their diversification and equity risk mitigation benefits in a balanced portfolio. A time will come to reach for yield when the environment to greater credit risk is more favorable, but it’s not today. A better opportunity awaits.

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all of the information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis nonfactual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.

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