Bond yields are hot, but be smart about how you invest. Here's where to begin

Published Mon, Feb 6 202310:53 AM ESTUpdated Mon, Feb 6 202311:56 AM EST

Higher bond yields are making the fixed-income corner of investors' portfolios exciting — but there is a right way and a wrong way to go looking for income. Bonds captured investors' attention in 2022 as the Federal Reserve embarked on its rate-hiking campaign to cool inflation. Bond yields and prices move inversely to each other so, as rates rose, prices tumbled — and did so at an inopportune time, since stocks were suffering, too. Consider that the iShares Core Growth Allocation ETF (AOR), which is allocated 60% to stocks and 40% to bonds, dropped 17% in 2022. But for investors seeking reliable income from interest payments at a low price, it was a great time to snap up some bonds. These days, you don't even have to chase junk bonds for attractive yields. Consider that six-month Treasury notes are offering yields of 4.88%, while three-month T-bills tout a rate of 4.69%. US1M US3M,US6M 1Y line T-bills are looking attractive as rates remain high. "Short-dated yields are up over 4% now, which is quite attractive," said Hans Olsen, chief investment officer of Fiduciary Trust. "With inflation coming down, there's a real possibility that people will earn a real yield on their cash balances, which is a remarkable state of affairs." Here's how to play those higher yields without getting burned. Looking to shorter duration Last year, investors seeking relative safety ran toward long-dated government bond funds. Those funds brought in $46.6 billion in net flows, the most among all fixed-income categories, according to data from Morningstar. Given the inverted yield curve — shorter-dated bonds have higher yields compared with their longer-dated counterparts — financial advisors are looking more closely at short-term bonds. Duration, a measure of interest rate sensitivity, is also a focal point when selecting bonds. Issues with longer maturities have higher duration. Thus, they have higher interest rate risk and greater price fluctuation. US2Y US10Y 1Y line The yield curve inversion has made the shorter-dated issues more attractive than their longer-dated counterparts. "People's risk appetite has been diminished after last year, and you need a year like last year to remind people that the risk is out there," said Thomas Balcom, a certified financial planner and founder of 1650 Wealth Management. He likes short-term Treasury bond funds and ETFs. "Rebalancing into these products, you can earn some return this year with virtually no risk," Balcom said. "It improves performance and risk parameters as well." That also raises the question of whether an individual bond or a bond fund best suits your circumstances. Consider that individual bonds make interest payments twice a year, but bond funds typically make monthly distributions that can be reinvested back into the fund or paid to the investor as cash. Bond funds offer easy diversification and can be appropriate for investors who'd rather not be hands-on. However, the market value of these funds fluctuates, while investors with individual bonds know what they will be getting if they hold to maturity. Strategies to squeeze yield The upshot of holding individual bonds is that you can use different strategies to manage interest rate risk. Laddering allows you to stack bonds of different maturities. As your near-dated bond matures, you can redeploy the proceeds into a longer-dated bond. The benefit is that you're smoothing out the impact of interest-rate fluctuations. Another laddering technique would use municipal bonds if you're looking for income that's exempt from federal taxes — and state income tax if the issuer is in your home state. "For muni bond ladders, we're willing to take a little more duration risk, but if you can find high quality municipals trading at a discount, it's all the better," said Ashton Lawrence, a CFP and partner at Goldfinch Wealth Management. Another way to mitigate interest rate risk is to use a barbell: You hold equal amounts of shorter and longer-dated issues. Once those near-dated bonds mature, you can take advantage of rising yields by buying another short-term bond. Quality is everything Moody's Investors Service, Standard & Poor's and Fitch provide ratings that reflect the credit quality of bond issuers. Investment grade corporate bonds rank from AAA to BBB, with top-rated issues having the lowest default risk. Nearly 90% of investment grade corporate bonds are rated either A or BBB, according to Bank of America. High-yield bonds, also known as junk bonds, are those issued by companies with lower credit ratings. Investors are compensated for the risk, so the bonds offer better yields. Consider that while the SPDR Portfolio Short Term Treasury ETF (SPTS) has a 30-day SEC yield of 4.23%, the SPDR Bloomberg High Yield Bond ETF (JNK) has a 30-day SEC yield of 7.57%. But while the annual default rate on investment grade bonds has been less than 1%, according to data from Moody's Investors Service, the annual default rate on high-yield bonds has ranged from 1.4% to 15.7%. High-yield bonds are also more correlated to stocks than other bonds are, which means adding them to your portfolio ramps up your risk. "Understand the credit and interest rate risk, as well as potentially the equity correlation investors take on when they jump for those high yields," said Michael Arone, chief investment strategist for the U.S. SPDR business at State Street Global Advisors. "You don't have to reach too far in terms of credit risk and interest rate risk to capture healthy yield in today's environment." — CNBC's Michael Bloom contributed to this story.