Higher Bond Yields Are Attractive. Should They Change Your Investment Strategy?

For years, one of the most common complaints from investors was that bonds simply didn’t pay enough.

Today, the conversation has changed.

Bond yields are considerably higher than they were during the years following the Global Financial Crisis. For investors who remember earning very little on CDs, money markets and high-quality bonds, today’s yields can look particularly attractive.

And they are attractive.

But there’s an important difference between recognizing an opportunity and allowing that opportunity to change a long-term investment strategy.

That distinction matters.

The Temptation of What We Can See Today

When interest rates are low, investors often wonder why they own bonds at all.

When interest rates are high, the question can quickly become:

“Why should I take as much risk in stocks when I can earn a pretty good return in fixed income?”

It sounds reasonable.

The problem is that investment decisions made in response to what feels especially attractive—or especially frightening—today often ignore something important:

Markets already know what we know.

Current interest rates aren't a secret. They are part of the information incorporated into market prices.

That includes stock prices.

Higher Rates Don't Necessarily Make Stocks Less Attractive

Wes Crill, PhD, Senior Client Solutions Director and Vice President at Dimensional Fund Advisors, recently addressed this question.

He points out that higher interest rates affect the discount rates investors use when valuing stocks. All else being equal, higher bond yields should therefore be associated with higher expected returns for stocks as well.

That's important.

It means we shouldn't automatically assume that because bonds now offer higher expected returns, the expected advantage of owning stocks has disappeared.

History gives us some perspective.

Crill looked at the historical equity premium—the additional return investors received from owning U.S. stocks compared with one-month U.S. Treasury bills.

During years when Treasury bill rates were below their historical median, the average equity premium was approximately 9.9%.

During years when rates were above their historical median, the average equity premium was approximately 8.1%.

At first glance, those numbers look different.

But statistically, the difference wasn't reliable enough to conclude that one interest-rate environment offered a meaningfully different equity premium than the other.

In simpler terms:

History doesn't provide convincing evidence that higher interest rates eliminate the reason for owning stocks.

Be a Historian, Not a Detective

This is where investment behavior becomes so important.

Investors naturally want to look at today's environment and determine what should happen next.

Rates are high, so buy more bonds.

Stocks have gone up, so perhaps reduce stocks.

Gold is performing well, so perhaps we need gold.

International markets have struggled, so perhaps we don't need international diversification.

Every one of these decisions can sound perfectly rational in the moment.

But they share a common problem.

We're trying to become detectives—using today's clues to predict tomorrow's winners.

I'd rather be a historian.

A historian asks a different question:

What has happened when investors faced similar circumstances before?

That's one of the reasons historical evidence plays such an important role in the way we invest at Epiphany Financial Coaching.

History doesn't tell us exactly what markets will do next.

It does something arguably more useful.

It reminds us how often the investment decision that feels obvious in the moment wasn't obvious at all when viewed later.

Bonds Still Have an Important Job

None of this means bonds aren't attractive today.

They are.

Higher yields improve the expected return available from fixed income, and that is good news for investors.

But bonds and stocks generally have different jobs within a portfolio.

Fixed income can provide stability, liquidity, income and a source of capital that may reduce the need to sell stocks during difficult markets.

Stocks provide participation in the long-term growth and profitability of businesses around the world.

The appropriate mix between those two shouldn't necessarily change simply because one happens to look particularly attractive today.

Your allocation should begin with questions about you:

What is the money for?

When will you need it?

How much liquidity do you need?

How much uncertainty can your financial plan tolerate?

What level of market volatility can you reasonably live with?

Those questions should drive the investment strategy—not today's headlines or today's interest rate.

The Heat of the Moment

One of the greatest challenges of investing is that we experience markets in real time.

Fear feels real in real time.

Excitement feels real in real time.

And today's opportunity almost always looks more obvious than tomorrow's uncertainty.

That's precisely when historical perspective becomes valuable.

Before making a significant change to an investment portfolio, I believe investors should ask:

Am I responding to a change in my financial circumstances—or am I responding emotionally to a change in the markets?

Those are two very different reasons for making an investment decision.

If your goals, income needs, time horizon or financial circumstances have changed, your portfolio may need to change with them.

But if the only thing that changed is the market environment, history suggests some humility may be appropriate.

Good investing isn't about figuring out what happens next. It's about building a strategy that doesn't require us to know.

This article was inspired in part by research and commentary from Wes Crill, PhD, Senior Client Solutions Director and Vice President at Dimensional Fund Advisors, including his discussion, “Are Higher Rates Cause to Add More Fixed Income?” Historical observations referenced above are based on the research presented in that commentary.

Want to talk about whether your stock/bond allocation still fits your financial plan?

Markets change. Interest rates change. Your investment philosophy shouldn't have to change with every headline.

If you'd like to review how your portfolio is positioned—and more importantly, why it's positioned that way—I'd be glad to have that conversation.