Overwhelmed by the choices? With interest rates on the rise, along with market volatility, choosing the right investing strategy has perhaps never been more crucial. From bond ETFs to mutual funds to U.S. Treasurys, each alternative presents special opportunities and challenges that face investment in your future.
Bond ETFs and mutual funds provide a single, highly convenient vehicle to add a professionally-managed portfolio of bonds to diversify your total portfolio. They enable you to tap into a wide array of fixed-income securities-from corporate bonds to mortgage-backed securities-across a wide spectrum of risk and return. In contrast, U.S. Treasuries come with unparalleled security as government-backed bonds, which easily make those issues a conduit for conservative investors seeking stability in turmoil.
But with so much diversity, how do you know which one is right for you? Should you have higher yields on corporate bonds you may find in an ETF and mutual fund, or are the safety of U.S. Treasurys more to your taste when it comes to risk tolerance? And what about the interest rate changes that factor into the value of your investment?
Here, we look at enormous differences among bond ETFs, mutual funds, and U.S. Treasurys. We will drill down through benefits and risks to assist you in making intelligent choices about your financial goals and risk appetite. By the end, you will know just what investment strategy holds the key to securing your financial future.
Bond ETFs and Mutual Funds
Exchange-traded funds (ETFs) and mutual funds that invest in bonds are a simple way to earn higher interest rates without locking in your money for a long time. These funds invest in a basket of bonds and other fixed-income securities, so you get instant diversification and professional management.
Many bond ETFs and mutual funds focus on investment-grade corporate bonds, mortgage-backed securities, or Treasury bonds. You can choose funds that target short-term, intermediate-term or long-term maturities depending on your needs. Short-term funds are less sensitive to interest rate changes but typically offer lower yields, while long-term funds often have higher yields but are riskier if rates rise.
Some popular bond ETF and mutual fund options include:
- iShares Core U.S. Aggregate Bond ETF (AGG)
- Vanguard Total Bond Market ETF (BND)
- PIMCO Income Fund (PIMIX)
- Dodge & Cox Income Fund (DODIX)
With interest rates on the rise, bond funds are an attractive option for investors seeking income and portfolio diversification. You can invest in these funds through a brokerage account, IRA or 401(k) to take advantage of their tax benefits as well. Shop around at different brokers to compare fees and fund offerings to find the right choice for your needs.
Corporate Bonds
Corporate bonds are issued by companies to raise money from investors. They generally offer higher interest rates than government bonds to compensate for the risk of default. If the company goes bankrupt, corporate bondholders may lose some or all of their principal. However, the higher yields can be attractive.
High-Quality Bonds
Bonds from large, stable companies with solid credit ratings typically offer the best combination of yield and safety. They’re unlikely to default, so the risk to your principal is minimal. Blue chip companies like Johnson & Johnson, Walmart, and Walt Disney frequently issue bonds with yields higher than government debt and strong repayment prospects.
Junk Bonds
Bonds from companies with lower credit quality (“junk bonds”) do come with substantially higher risks, but also much higher interest rates, often over 5-10% annually. If the company avoids bankruptcy, the rewards can be substantial. However, if the company defaults, investors can lose their entire investment. Junk bonds should only be considered by experienced investors who can afford to take on additional risk.
Duration Risk
The longer a bond’s duration, the more its price will drop when interest rates rise. Long-term corporate bonds with 15-30 year maturities offer the highest yields but also the greatest interest rate risk. If rates move up sharply, the bond could fall significantly in value. For most investors, intermediate-term bonds with 3-10 year maturities offer an optimal balance of yield and interest rate risk.
Corporate bonds provide an opportunity to generate solid returns with reasonable risks. Focus on high-quality, intermediate-term bonds and consider adding a small allocation of higher-yielding junk bonds. With the potential for higher rates and stable companies, corporate bonds deserve a place in most portfolios.
U.S. Treasurys
U.S. Treasury securities, like Treasury bills, bonds, and notes, are considered very low-risk investments backed by the full faith and credit of the U.S. government. When interest rates rise, the yields on newly issued Treasurys also go up. This means you can take advantage of higher rates by investing in short-term Treasurys.
- Treasury bills (T-bills) mature in less than a year. You can find 1-month, 3-month, 6-month, and 1-year T-bills with interest rates higher than most CDs and savings accounts.
- Treasury notes (T-notes) mature in 2 to 10 years. If interest rates rise, the yields on new T-notes will be higher than older notes, so you can invest in new notes to lock in the higher rate.
- Treasury bonds (T-bonds) mature in 10 to 30 years. Like T-notes, the yields on newly issued T-bonds will reflect higher overall interest rates. T-bonds pay interest semiannually and the principal amount when they mature.
The yields on Treasury securities move in the opposite direction of Treasury prices. So when rates go up, the price you pay for existing Treasurys goes down. But if you hold Treasurys to maturity, you’ll get your full principal back plus interest. Treasurys are highly liquid, so you can sell them on the secondary market if needed. But if rates have gone up since you bought, you may have to sell at a loss.