A Wall Street Journal Your Money Briefing podcast appeared on my feed shortly after the recent Fed interest rate cut. The title was As Interest Rates Fall Bonds Become a More Attractive Investment.

This immediately prompted me to ask a question: Is that true?

I primarily try to write timeless articles for this site. Occasionally, it makes sense to address current events. Addressing this question is a perfect opportunity to accomplish both at once.

Let’s review why we hold bonds in our portfolios and consider how falling interest rates should impact that decision.

Better Questions → Better Answers

Before we answer whether bonds become more attractive as interest rates fall, we need to answer a few other questions.

Which Bonds?

The first question to ask is what we are talking about when using the term bonds. “Bonds” is a generic term representing a wide variety of potential investments. Many investors lump them all into one bucket.

The Morningstar Fixed Income Style Box™ offers a nice visual representation of the range of holdings that you may consider part of your bond allocation.

A 30-day T-bill issued by the US treasury lives in the upper-left corner. It has minimal sensitivity to interest rate changes and is virtually free from default risk.

A 20+ year bond issued by a corporation with a low credit rating lives near the lower-right corner. It comes with considerable interest rate and default risk.

Various bonds with different credit ratings and interest rate sensitivities fill these boxes. All bonds are not created equally. It is important to understand this when building and managing your portfolio.

Compared to What?

Another question to answer before answering whether bonds become more attractive as interest rates fall is…. compared to what? 

Compared to stocks, cash, gold, or crypto? Compared to bonds the day before rates were cut? Do longer-term bonds become more attractive compared to shorter-term bonds? Or vice-versa?

More Attractive to Whom?

We also have to answer another question. More attractive to whom?

To existing bond holders? To people with cash they are looking to deploy? Or maybe to stock investors looking to derisk or diversify?

This podcast wasn’t clear on these questions. Investors, bombarded with these types of headlines from financial media, often aren’t clear either. Yet they hear this “conventional wisdom” and it drives investment decisions. 

Let’s try to do better.

A Framework for Discussing Bonds

A few years ago interest rates were at historic lows. The Federal Reserve took drastic actions to steer the economy through unprecedented conditions created by the COVID pandemic.

At that time, I reviewed the three traditional roles bonds historically played in portfolios and asked if they still made sense in times of extremely low interest rates. Bonds are used to:

1. Provide stability,
2. Create income, and
3. Diversify a portfolio, hopefully appreciating in value when stock prices are falling.

That framework proved salient in understanding losses in the bond market as interest rates increased rapidly coming out of the pandemic.

Let’s return to this framework to evaluate the premise that falling interest rates make bonds more attractive.

Stability in a Falling Interest Rate Environment

One reason investors hold bonds in a portfolio is to provide stability and liquidity. We want something that will be reliable when stocks are volatile. This is particularly important for retirees and near-retirees.

Not all bonds are created equally. Many investors learned this lesson the hard way when core bond funds lost about 20% of their value in 2022.

Short-term US treasuries (T-bills) best fit the role of providing stability. That is because they provide:

1. High quality
2. Short duration.

Short of default of the US government on their debts, they will provide stability regardless of interest rate levels or movements. But are they more attractive as interest rates fall? In a word, no!

While providing stability, a secondary benefit of these short-term bonds is creating interest income. T-bills mature quickly (by definition in less than one year). Once they mature, you lose the rate you had on that T-bill and have to reinvest at the new prevailing rate. This is called reinvestment risk.

When rates drop, that new prevailing rate will be lower than your old rate. This makes these bonds less attractive when interest rates fall.

Income in a Falling Interest Rate Environment

Another reason we invest in bonds is for the interest income they provide. Typically intermediate-term bonds fill this role. 

Intermediate-term bonds typically have higher yields than short-term bonds (though that has not been the case recently). If you buy any bond and hold it to its maturity, then falling (or rising) interest rates are irrelevant with regards to income you will receive. 

Assuming you invest in high-quality bonds (with little to no default risk), you receive the same interest rate you agreed to until the bond matures. At that point, if you want to reinvest you are subject to the same reinvestment risk as discussed above with T-bills.

If you add to your bond position, new bonds will provide less income than you could have had on bonds with higher rates before the rates fall. You should find this less attractive. You now have to pay the same principal to receive less income. In other words, bond income becomes more expensive as yields fall.

When interest rates fall, old bonds become more attractive to investors because they have higher yields than new bonds issued with lower yields. However, this is common knowledge to investors. 

This is why these bonds sell for a premium. The premium is the additional amount you have to pay above the face value of the bond. The premium is proportional to the duration of the bond and the magnitude of the change in interest rates.

Related: Understanding Bond Duration

So falling rates make bonds more expensive. You either have to pay a premium to buy old bonds or you buy new bonds with a lower yield than you could have bought them for before rates fell.

In either event, this means bonds have become more expensive. This makes bonds less attractive from an income perspective.

This takes us to our final role of bonds.

Bond Price Appreciation When Rates Fall

As noted above, when interest rates fall existing bonds become more valuable. If you can hold your bonds, you will receive a higher rate than you could get from new bonds. If you need to sell, you can do so at a premium. Win-win!

If you knew with certainty that rates would continue to fall, then this would indeed make bonds more attractive. Unfortunately, we can not predict the future with any certainty. Yet this is where the financial media, and as a result many individual investors, tend to focus attention.

Predicting the future is inherently hard. Most investors accept this as fact concerning the stock market. While equally true, many people don’t understand how hard it is to predict future interest rates.

How Should Interest Rates Impact Portfolio Decisions?

Interest rate forecasts should play the same role in portfolio decisions as stock market forecasts. Little to none!

If you need a portion of your portfolio to have liquidity, and most retirees do, you should set aside an appropriate amount to meet that need.

Remember, the primary purpose of this part of your portfolio is stability. If you can squeeze out extra income without taking additional risk, go for it. Just don’t forget the primary reason for these holdings.

Related: Getting Higher Returns on Your Cash

Similarly, match the duration of the remainder of your bond allocation to the timeframe when you likely will need it. This can be accomplished by building a bond ladder, with each bond maturing at a specific time you choose. Using bond funds with duration-matched to your approximate time horizon also works well.

What doesn’t work well is listening to forecasts, trying to predict the future, and constantly changing strategies based on what is “attractive” at the moment. 

Develop a plan. Understand it. Stick to it.

Understand the roles bonds play in your portfolio. Know how interest rate changes impact those variables. 

If necessary, alter your expectations. But proceed with caution before altering your strategies.

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. After achieving financial independence, Chris began writing about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. Chris also does financial planning with individuals and couples at Abundo Wealth, a low-cost, advice-only financial planning firm with the mission of making quality financial advice available to populations for whom it was previously inaccessible. Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He has spoken at events including the Bogleheads and the American Institute of Certified Public Accountants annual conferences. Blog inquiries can be sent to chris@caniretireyet.com. Financial planning inquiries can be sent to chris@abundowealth.com]

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