What Makes the U.S. Bond Market Appealing Now?

MIKE TOWNSEND: After months of campaigning, billions of dollars of advertising, countless annoying text messages, an historically late change in candidates by one of the major parties, two assassination attempts, and a blizzard of polls, we have finally arrived at Election Day 2024. Next week, voters across the country will go to the polls to vote in one of the most consequential elections in memory. 

For investors, however, it's likely that the uncertainty in the markets has just begun. With most analysts expecting an historically close presidential race and razor-thin majorities in both the House and the Senate, it may be days, perhaps even weeks, until we know for certain the results of the election. There could be legal challenges and recounts and court rulings that delay the answers.

And while we're waiting for election results, the Federal Reserve's Open Markets Committee will host a regularly scheduled two-day monetary policy meeting that begins the day after the election. On November 7, they'll announce their decision, which is widely—though not universally—expected to be a continuation of the rate-cutting cycle that started in September.

That's a lot of unknowns coming together in a span of a couple of days next week. So how can a fixed income investor navigate these uncertainties?

Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.   

In a few minutes, I'll be joined by Collin Martin, fixed income strategist here at the Schwab Center for Financial Research, to talk about how the bond market is thinking about the election and the upcoming Fed meeting, and where the opportunities are for fixed income investors.

But first, a quick update from Washington and my final thoughts on what to watch for in next week's election. 

First off, we are at the point in the calendar where the IRS makes a series of announcements about next year's taxes so that taxpayers can plan for any inflation adjustments. Last week, the IRS announced several important ones, including the 2025 levels for the estate tax and the annual gift tax exemptions, as well as the new standard deduction amount and changes to individual income tax brackets. Next year's numbers reflect about a 2.8% inflation adjustment. 

So that means that the amount of assets that can be inherited without triggering the estate tax will rise from $13.61 million today to $13.99 million per person in 2025. And the amount that can be gifted to another person tax-free will bump up from $18,000 to $19,000 per gift next year. 

The standard deduction next year will rise to $15,000 for an individual and $30,000 for married couples filing jointly, up from $14,600 and $29,200, respectively.

The IRS also set the 2025 tax brackets. The top income tax rate of 37% will start next year for individuals earning more than $626,351 or for couples who earn more than $751,601.

You can find all of these numbers, along with other changes to tax provisions, in an IRS announcement on its website. We'll put a link to it in the show notes for this episode.

The IRS also makes annual inflation adjustments to the contribution limits for retirement accounts, including 401(k)s and IRAs. Those limits will be announced sometime in the next few weeks.

Of course, all of these adjustments for 2025 will take effect in the context of a looming debate over taxes in Congress next year. And that's because all of the 2017 tax cuts, which were approved in the first year of President Trump's administration, are set to expire at the end of 2025. So the numbers I just referenced, including the standard deduction amount, the individual income tax rates and brackets, and the amount of assets that can be inherited without triggering the estate tax, are set to revert to their pre-2017 levels in 2026 if Congress does not extend these provisions by the end of next year. It's the biggest policy issue on the docket in 2025, and one I'll be following very closely.   

The tax debate in Congress will be shaped by the outcome of next week's election. So here's what to watch for on Election Night, and, I suspect, in the days beyond. 

The presidential race remains essentially tied, with all seven battleground states—Arizona, Georgia, Michigan, Nevada, North Carolina, Pennsylvania, and Wisconsin—having average polling margins that are well inside the margin of error. It simply could not be any closer. Both candidates are making their closing arguments, barnstorming around the battleground states, and trying to persuade unenthusiastic voters. These are less politically engaged voters who don't tend to vote in every election, who despite the seemingly never-ending coverage are not really paying much attention to the race—or, conversely, are so sick of the barrage of advertisements and text messages that they are angry with both candidates. These voters are not necessarily choosing between the candidates but rather deciding whether to vote at all.

So what will I be watching on Election Night? Three quick thoughts:

First, I think the most important state will be Pennsylvania. Whichever candidate can win Pennsylvania is likely to be the next president. 

Second, my barometer states are North Carolina and Michigan. If Kamala Harris wins North Carolina, it's likely a very good sign for Democrats across the board. And if Donald Trump wins Michigan, it likely signals a big night for Republicans. Those are states that probably should go the other way, so they're good bellwethers for trends.

Third, I'm keeping my eye on third-party candidate numbers in the key states. Despite Robert F. Kennedy, Jr., ending his independent bid and endorsing Donald Trump in the late summer, there is still a Green candidate, a Libertarian candidate, a progressive Independent candidate, and other fringe-party candidates on the ballot in key states. They won't get big numbers, but in a race this close, even small numbers going to a third-party candidate can be the difference between winning and losing. As I like to remind people, in 2016, Donald Trump beat Hilary Clinton in the state of Michigan by fewer than 11,000 votes. There were 275,000 votes cast in Michigan that year for candidates not named Trump or Clinton. 

It's very likely that we won't know who has won the presidency for a few days after Tuesday. Don't be surprised if market volatility increases next week if there are several days of uncertainty while ballots are being counted.

In the battle for control of the Senate, Republicans continue to have the upper hand. Democrats currently hold a narrow 51-49 majority, but it is widely assumed that the Senate seat in West Virginia will flip to Republicans, since moderate Democrat-now-Independent Joe Manchin is not running for re-election. That means things are starting out at a 50-50 tie. Republicans are very confident that they can flip the Montana seat, where three-term incumbent Democrat Jon Tester has been trailing in the polls for weeks. Close races are expected for Democrat-held seats in Ohio, Michigan, Pennsylvania, Wisconsin, and Nevada. And there's really only one seat I'm watching that is currently held by a Republican—that's in Texas, where incumbent Senator Ted Cruz is in a close race against former NFL player Collin Allred, a Democrat currently serving in the House of Representatives. An Allred win would be a big surprise and likely signal a big night for Democrats nationally.

But overall, I continue to think Republicans have a huge advantage going into the election and are likely to emerge with a majority of a couple of seats in the Senate.

But as I have said before, I think Democrats have a slight advantage in the battle for the House of Representatives. Out of 435 House races, the non-partisan Cook Political Report had just 25 rated as toss-up races at the beginning of this week, and just 18 more as leaning slightly to one party or the other. Polling is often difficult in Congressional districts, and several of the toss-up races have seen little to no polling. I continue to keep my eye on the races where a Republican is representing a district that voted for Joe Biden in 2020 or a Democrat is representing a district that supported Donald Trump in 2020. These are your classic "swing" districts. And this year, there are 17 Republicans in those kinds of seats and just five Democrats. To me, that gives Democrats, who need to net just four seats on Election Day to win the majority, a slight upper hand. 

Like the presidential race, it's possible, even likely, that we won't know which party wins the majority in the House of Representatives for a few days. There are some key toss-up races in California, New York, Pennsylvania, and Washington state, all of which are known as states that can take a long time counting ballots. 

So be patient, and know that whatever happens next week, this election will get sorted out one way or the other in time. Even if it takes a few days, even if it spurs controversy and legal challenges, it will be behind us soon enough. I'll be out with a new episode of WashingtonWise on November 14. By then many decisions should be sorted out, and I'll explore the implications of the outcome on the key policy issues and the markets.

On my deeper dive today, we're going to consider how the bond markets might react to the two big events next week, the election, and the Fed's next monetary policy decision. And we'll take a closer look at the state of the bond markets in general to understand where investors may find opportunities. To do that, I'm pleased to welcome back to the podcast Collin Martin. Collin is a fixed income specialist here at Charles Schwab, and he holds the Chartered Financial Analyst designation. Collin, thanks so much for joining me today. 

COLLIN MARTIN: Hi, Mike. Thanks for having me.

MIKE: Well, Collin, next week is kind of a double whammy for the markets, the election and the Fed meeting. So let's begin with the election. Over the past few months, I've been talking to investors all over the country about how the stock market has historically reacted to presidential elections, but I don't talk much about how the fixed income markets react to elections. So I'll ask you, historically, what has the impact of elections been on the bond market? 

COLLIN: The impact has been mixed over time, but it's not something we focus on too much. It's a factor of course, but we think that Fed policy expectations, and really just the economic outlook, matter more than what may or may not happen with a given election. 

So over the last 10 elections, we've looked at what the 10-year Treasury yield has done, and on average, the 10-year Treasury has fallen by 10 to 15 basis points in the one, three, and six months following an election. But here, Mike, I want to steal a line that our colleague Liz Ann Sonders likes to say, "Analysis of averages leads to average analysis." And me giving you those average declines does not tell the whole story. 

If we look at what's happened on a one-month change basis, six times that 10-year Treasury yield fell; four times it rose. And if we look at the three-month change, the yield was down four times, the yield was up four times, and twice it was close to flat. And if we look at that movement, whether it was up or down, it's really varied whether a Republican or Democrat won the election. 

So summing that up, it's not something we focus on too much. Again, we're focused more on Fed policy, as well as growth and inflation expectations. 

MIKE: Well, Collin, I want to follow up on some election questions, but you just discussed the change in yield, and I want to make clear what that means for bond prices. I know there's an inverse relationship between a bond's price and a yield, but can you take a moment and just explain that for our listeners? 

COLLIN: I think it's one of the most important characteristics of bond investing, and it's really important to understand when you're considering bonds and owning bonds, and it's that the price and yield move in opposite directions. I think that surprises a lot of investors. And this really happens because bonds trade in the secondary market. I think that also surprises a lot of investors too, where I think it's common to invest in a bond. And when you do that, you're lending to an issuer, whether it's the U.S. government, a municipality, a corporation, with a promise of repayment at maturity and a stated interest rate. But once you buy a publicly traded bond, it trades in the secondary market, so the value of that bond can vary depending on market conditions. So let me go through an example of why we see those prices change. 

Let's assume, Mike, that you bought a two-year Treasury note at 5% recently. I'm going to use round numbers here. And then let's assume a few weeks later the Treasury issues a new two-year note, but now that yield is 5.5%. And it rose for any number of reasons. We don't need to get into the why. Let's just acknowledge that the yield went up. So you're holding a bond that's paying 5%, but new investors can earn 5.5% on that new Treasury note. So if you wanted to sell your bond, most investors really wouldn't be too interested in buying that bond from you, knowing that they can earn a higher yield with that new bond. So they might offer you a lower price to kind of make up for the fact that they're earning less in yield. And now, of course, the opposite occurs if yields fall, that the price of a given bond can go up as well. That's why that standard relationship exists. It's really important to understand for anyone considering owning bonds. 

So when we talk about those yield changes I alluded to before with the election impact, any yield change would result in the opposite for the price. But as I mentioned, it's really not something we're focusing on too much as we come up with our outlook for the end of 2024 and into 2025. 

MIKE: Yeah, I really appreciate that explanation. I think that's always a confusing point for bond investors. So just wanted to make sure everyone is on the same page before we continue on.

Back to the election. What about this election in particular? Financial news channels right now are filled with these interviews with stock market analysts who opine about which sectors are going to thrive if Trump wins, or if Harris wins, which stocks will benefit depending on the outcome. I've always thought most of that was nonsense―history shows that most of it is nonsense. But does something equivalent go on with the fixed income markets? Are you seeing any signs of what the bond market is expecting as a result of the election? 

COLLIN: Over the past six weeks or so, Treasury yields have risen sharply, and there's a number of people who are attributing that increase to the rising possibility of a Trump victory, and we're seeing that based either on polls or the betting markets. And then because that victory has implications in terms of some of his key policy proposals, like tariffs and tax cuts, and that they could ultimately be inflationary. So if you think about tariffs, they can be inflationary, since they could raise the price of imported goods and raise the price of what we as consumers pay. And tax cuts can be inflationary, as well, because that would really just put more money in consumers' pockets in an environment when consumer spending is already really strong. 

If we look at inflation, a simple way of explaining a key driver of inflation is too much money chasing too few goods. So if tax cuts give people more money, people start spending more. That increased demand could pull prices up. So we could see inflation go up a little bit in that instance as well. There's also concern about the deficit. Frankly, that's a concern for both candidates. If deficits are rising, they generally need to be financed with new debt. And there's a concern that Treasury yields might need to adjust higher to attract new buyers. So when you take all that into consideration, there's a number of people who are pointing to the rise in Treasury yields, given those factors, and the possibility of Trump winning versus Harris.

We don't necessarily agree with that. I think there's some credence to it, but that's not our rationale. We see it a bit differently. We're chalking up the rise in yields to just the strong economy and the overall economic resilience that we've been seeing. Now, there's some pockets of weakness here and there, but gross domestic product is rising at an above-trend pace. The labor market appears to have reversed some of the weakness that we saw earlier this year. We saw the unemployment rate rise over the course of 2024, but then it actually came down a little bit over the past few months. We're seeing wages continue to rise. 

So if people have jobs, and if they're seeing even modest wage gains, we think that that can keep the economy kind of chugging along. We think the move up in yields is really just attributed to that, and what that impact might be on Fed policy because if the Fed ends up cutting rates less than expected, that can actually result in higher yields. Because if you think about intermediate and long-term yields, they're based on expectations of where the fed funds rate might ultimately get to, and if it's going to be at a higher landing point, I think that's what's pulled up Treasury yields lately.

MIKE: Well, Collin, I want to get to the Fed in just a second, but a couple more questions on the election. One of the things that I'm seeing a lot of when I talk to investors is concern about volatility coming from a period of uncertainty about the election outcome, whether that's days or maybe even longer not knowing who won. How does the bond market think about that? Is there a concern in the bond market about extended period of uncertainty and how that'll affect things? 

COLLIN: In a truly uncertain outcome, if we're talking days, or worse, weeks, I'd expect Treasury yields to fall and their prices to rise. And that's generally because Treasuries are perceived to be one of the safest investments available. And when there's a lot of uncertainty, demand for these perceived safe investments tends to increase, and that pulls their prices up and their yields down. 

Now, there would still be concerns, I think, long term around who wins about future policies, and what does that mean for debt and deficits. But just in the here and now, if there is that uncertainty, people usually go to the perceived safe-haven investments. We actually saw that during the 2000 election. We saw Treasury yields fall as the outcome was a bit uncertain. 

Now, I'm just talking about Treasury yields there, and Treasury yields would likely fall with their prices up. If we look at riskier parts of the market, we'd probably see their prices fall because it just goes in line with a risk-off environment. If people are going to the perceived safe investments, they usually get out of the perceived riskier investments. So things like high-yield bonds could suffer.

MIKE: I am seeing a lot of anxiety out there among investors about the election and how things will play out. What do you suggest fixed income investors who are anxious about this election do? 

COLLIN: If you're anxious about the election and kind of worried about what to do with your bond holdings, I think it's important to remember what bonds are and then how they fit into your portfolio. Regardless of the interest rate environment, or regardless of the political environment, bonds have some key benefits that are important to keep in mind. The income payments they provide, the capital preservation, especially if you're in very high-quality investments, and the diversification benefits that they offer. We like to think that bonds can provide ballast to a portfolio. I like to say that they allow you to take risk elsewhere, because if you invest in high-quality investments, you can know, with relative certainty, barring default, of how much money you'll get and when you'll get it back. 

And then beyond that focus on the yields that bonds offer today and how they can help you reach your goals. Most Treasuries today offer yields of 4% or more. Now, it's not quite at the levels that we saw, say, in the fall of 2023, but they're still well above the levels that we saw in the years leading up to the pandemic, and I think that's really important. 

Now, in terms of strategies, bond ladders are a really great ways to invest in bonds if you're anxious. We also think they're great ways to invest in bonds really regardless of what the interest rate environment is because it can help take the guesswork out of investing. If you're interested in a bond ladder, it's just a way of investing in individual bonds where the maturities are staggered out. So for example, you might build a 10-year bond ladder where you hold 10 bonds, with a bond maturing each year. And as each bond matures, you can either reinvest them to keep the ladder intact, or you can use the maturing proceeds for something that aligns with your goals and objectives based on your financial plan. 

But I mentioned how it can take the guesswork out of investing because it keeps you invested, and you can really benefit in either environment. If yields are rising and you're in a bond ladder, you can use those maturing proceeds to reinvest at those higher yields. Now, on the flip side, if yields are falling, maturing proceeds might be reinvested into lower-yielding bonds, but you'll have invested in some higher-yielding bonds with longer maturities where you've locked in those higher yields. So it can really work in both environments, but most importantly, it's a way to stay invested in the bond market and not try to time it. 

MIKE: Yeah, I love the bond ladder idea. I think for anxious investors, in particular, who are worried about the election, it does offer some stability and takes a little bit of the worry away. 

Well, let's turn to the Fed meeting, which by very weird coincidence of timing starts literally the day after the election, wraps up on November 7, which is when we'll find out whether there will be another rate cut. It's a rare Fed meeting that may not be the headline news of the day, given that it is likely that the election will still be getting sorted out. But all signs point to a 25-basis-point rate cut next week. Is that your view as well? Do you see any scenario in which the Fed pulls a bit of a surprise and maybe holds the rate steady until the December meeting? 

COLLIN: We do expect a 25-basis-point rate cut at next week's meeting. A pause could happen. They could surprise us. If the Fed were to pause, we don't necessarily think it would be election related, especially if things are still being sorted out. We think it would really just be driven by the strong economy. The Fed is very data dependent right now, and they want to make sure that they're not having rates too high—that slows the economy too much—but they don't want to cut them too fast too quickly in an effort to stimulate the economy. 

So the Fed is really looking to maintain the level of restriction that they have right now, and a cut can still do that. Because when the Fed looks at what its rate is, they look at it relative to the rate of inflation, and they want to maintain the difference between its rate and the rate of inflation because that difference is called a real rate, or inflation-adjusted rate. So as inflation comes down, the Fed can still lower rates but maintain that gap where real yields, that inflation-adjusted yield, is still positive. 

But again, they're kind of threading the needle here, Mike, and they're in risk management mode. They don't want to stimulate the economy by cutting too much. They don't want to hold for too long and choke off the economy. So I think it really will be a meeting-by-meeting basis. Even though we do expect them to cut next week, we think a pause is probably likely at some point, as they kind of recalibrate and see how the economy's doing. 

One thing that we're focusing on, though, and why we think a 25-basis-point cut is still likely is the fed fund's futures market is pricing in a near 95% likelihood of a cut. And the Fed generally doesn't like to surprise the markets too much. So with such a high probability, unless that changes over the next week or so, we do see a cut as likely. But we think a pause at some point, whether it's November, whether it's December, whether it's sometime early in January, we do think a pause can happen, especially if the economy remains resilient and if the labor market remains strong. 

MIKE: Collin, what's the relationship between the fed funds rate and other parts of the market? The Fed cut rates last month, as we all know. Now, a lot of bond yields, like the 10-year Treasury that we were talking about earlier, are higher now than they were before the Fed cut rates. So can you help us make a bit of sense of that? And also, do you think that leads to an opportunity for investors to consider some longer-term bonds, since their yields have risen a bit? 

COLLIN: I'll try to help make sense of this all because it is counterintuitive, Mike, that the Fed cut rates in the middle of September, and then since then the 10-year Treasury yield is up nearly 70 basis points, or 0.7%. I'm going to talk more about that strong economy, the resilient economy that I've alluded to. And when we look at what drives intermediate- and long-term yields—and we'll use the 10-year Treasury yield as an example—they're based on expectations of where Fed policy will be over the next handful of years. And usually the 10-year Treasury yield moves in anticipation of what the Fed is expected to do. So when the Fed is expected to begin hiking rates, you tend to see the 10-year Treasury yield rise in anticipation, and then as they're expected to cut rates, you see them fall in anticipation. And they tend to fall near what we call the terminal rate, or the rate where the Fed stops a given cycle. 

So if we go back six, eight, 10 weeks or so, we were in the camp that the Fed would probably cut rates to the 3% area, give or take, who knows, but probably somewhere near 3%. And we saw the 10-year Treasury yield fall to around 3.6%. Since then, we've gotten a string of strong economic data that says maybe the Fed doesn't need to cut as much. So if the Fed only cuts to that 3.5%, or maybe even higher, maybe 4% range, that supports the case for these intermediate  and long-term bonds to be a little bit higher than they initially fell. So I think it's really just a reversal of what we saw based on Fed expectations. 

The recent rise, though, I think this is important, we do believe it's presented an opportunity for investors to again consider intermediate or long-term bonds, in moderation of course. This is a strategy we had been suggesting for most of 2023 and most of 2024, the idea of locking in high yields with certainty by considering some intermediate or long-term bonds, rather than reinvestment risk or reinvesting at lower yields with short-term as the Fed cut rates. But then when the 10-year Treasury yield fell so much at the end of the summer, we kind of backed off that guidance a little bit as that risk-reward didn't look as attractive. But now that yields are back up again, we think it's relatively attractive again. 

So if you're an investor, if you thought you missed the opportunity, we think it's back. And we think the recent rise in yields has presented it for those who may be still waiting on the sidelines.

MIKE: Well, there's obviously a lot going on in the fixed income markets outside of just the election and the Fed meeting. One of your big areas of focus is corporate bonds. We're into earning seasons, so stock market investors are focused on that. But earnings and stock market performance also impact the interest rate that corporations could offer on their bonds. There's been some notable analysis from Wall Street firms that the next decade could see a lower growth rate for equities. Does that create some opportunities for corporate bond investors? 

COLLIN: We look at it a bit differently on the corporate bond side relative to stocks. When we look at stocks, the income statement matters a little bit more. What's the earnings potential for a given stock, and what's then the earning multiple? We think that's a really a key driver of performance. For bonds, we look at it differently. We look more at the balance sheet. We look more at assets and liabilities. Now, earnings play a role in that of course, but we're more focused on the ability of an issuer, or issuers in aggregate, to make timely interest and principal payments, because that's what's important for bond holders. Am I going to get my money back? Am I going to get my money back on time? And today, we think that ability is really high, and it's a key reason why we've held a pretty favorable view of corporate bonds, specifically investment-grade corporate bonds, which are those rated AAA to BBB. It's why we've had a favorable opinion over the past year or two. 

If we look at the big picture of corporate fundamentals, we think corporations are generally in good shape, especially those with those high credit ratings, with those investment-grade credit ratings. We look at data from the Federal Reserve, and that gives us a snapshot of their balance sheets, and we see that corporations have plenty of liquid assets on their balance sheets, both in absolute terms and relative to their short-term obligations. Corporate profits have been a key driver of that. Corporate profits, as measured by the Bureau of Economic Analysis, are at all-time highs. Now, I said I focus less on earnings, but those record profits played a large role in the strengthening of their balance sheets. It's helped with cash flow. It's helped with retained earnings. It's given these corporations those liquid assets that they have on their balance sheets. So even if earnings growth were to slow a bit—and maybe that's a risk for stocks—we're not too worried about it on the investment-grade corporate bond side because we think the ability to pay would still be pretty high. 

When we evaluate corporate bonds, we focus on both fundamentals and valuations, and valuations just aren't that great for investors today. When we look at corporate bonds, we look at spreads, or the extra yields that a corporate bond offers relative to Treasuries, and today spreads are very low. The average spread of the Bloomberg U.S. Corporate Bond Index has been less than 1% for most of this year. So that means investors earn, on average, one percentage point more than a comparable Treasury. In fact, at the end of October, spreads were closer to 80 basis points, or 0.8%. So that's just very, very low by historical standards. But even though spreads are low, yields are still high. So that's really what we are focusing on these days. Average yields for investment-grade corporates are near 4.5% or more, maybe close to 5%, depending on the credit rating or term. And we think that's attractive for investors willing to take a little risk to earn higher yields.

MIKE: What about taking even more risk, perhaps a high-yield bond? What is your thinking on high-yield bonds right now? 

COLLIN: We're a little bit more cautious there, and we're not that interested in taking too much risk, mainly because of those valuations. So if I go back to spreads, the average spread of the Bloomberg U.S. Corporate High-Yield Bond Index is less than 3%, or three percentage points. That's also very low, near its historical lows. And when we look at high-yield bonds, they can be very volatile, especially if the economic outlook were to deteriorate. And such low spreads, it doesn't provide much of a cushion should those prices fall. So investors can consider them in moderation but be prepared to hold them for a long time and ride out potential ups and downs. 

And then I think about how you would consider them in a bond portfolio. When we start talking about how to invest in bonds with investors, we think it makes sense to look at a core-satellite approach. We think it makes sense to start with core bonds. Those are investment-grade-rated high-quality bonds, like U.S. Treasuries, investment-grade corporates, agency mortgage-backed securities. We think they should make up a bulk of the fixed income holdings. And then consider riskier investments like high-yield bonds in moderation, depending on your risk tolerance and depending on valuations. And with those valuations so tight, with spreads so tight, we just don't think now is a time to be taking outsized risks with high-yield bonds. 

MIKE: One other thing I wanted to ask you about, Treasury Inflation-Protected Securities, or TIPS. They were the hottest thing around a couple of years ago when inflation was high. Now, as inflation returns to normal levels, what's the current thinking around TIPS? What do investors who bought TIPS at the peak do now? 

COLLIN: We like TIPS right now. We think they can play a role in investors' portfolios, especially if they're worried about inflation. But let me first explain what TIPS are because I find that they tend to be misunderstood. TIPS are Treasury securities whose principal values are indexed to the Consumer Price Index, which is a measure of inflation. So as inflation rises, so too does the principal value. So that can be a great way to protect against inflation over the long run. Second, talking about understanding how they work. It's really important to understand how they work because they do have a lot of nuances. And if we go back to 2021 and 2022, they actually didn't perform too well, even as inflation was making multi-decade highs. And that's because TIPS are still bonds, and they still have that inverse relationship with their prices and yields. And if we go back to 2022, and the Fed began to hike rates, TIPS yields rose so much that their prices fell, offsetting that inflation adjustment, and more than offset that inflation adjustment, that total returns were actually negative. So I think that surprised a lot of investors. It caught a lot of investors off guard. So I think that's something to consider and maybe might help if you're considering TIPS to maybe consider individual TIPS where you hold them to maturity, where you can kind of look through potential price declines, versus maybe a fund whose net asset value hasn't necessarily recovered yet. But there's also pros and cons to funds where you get more diversification at a relatively low fee as well. So that's something to consider. 

But in terms of what our outlook is now, Mike, we think they can make sense for two key reasons. One is the positive real yields that they offer. When you look at a TIPS yield, that is already inflation-adjusted. So if you consider a, say, five- or 10-year TIPS, and it shows a yield of, say, 1.5 to 2%, that's what you'll earn, on average, annualized, over the rate of inflation. So regardless of what inflation does over the holding period of that TIPS, you should outperform it by what that starting yield is. So I think that's really important that you can lock in positive real yields right now and then still benefit if inflation were to move higher from here. 

And then when we look at relative valuations of TIPS versus U.S. Treasuries, there's something called the break-even rate. It's the difference in the yield of a TIPS and a traditional Treasury, and it's what inflation would need to average over the life of that TIPS for it to outperform the Treasury. And that break-even rate for TIPS is currently around 2.25%, 2.3%. So if you're worried about inflation, and if you think inflation's going to reaccelerate from here and be stickier than expected, then that break-even rate might be considered a little bit low. So TIPS can make sense and can outperform traditional Treasuries, especially if inflation were to accelerate. 

Now you asked about what to do if someone bought TIPS or especially bought them at their peak. And that depends on your situation. Why did you buy TIPS? What are your goals and objectives? I think consider it the way you would consider any of your investments. Does it still make sense based on your outlook now and what your goals and objectives are? But I will say this. If you hold TIPS and you're worried about inflation reaccelerating or staying sticky, TIPS can still make a lot of sense. 

MIKE: Well, Collin, we've covered a lot of ground today. This has been a great conversation. Let's just wrap up with your overall outlook for fixed income investors. We've touched on some different ideas. Maybe just sum it all up. Where do you see opportunities for the remainder of the year and into 2025?

COLLIN: We still see a lot of opportunities through the end of this year and into next year, mainly because of the yields that high-quality bonds offer right now. While they're off their highs, they're still well above levels that we saw in the years leading up to the pandemic. And even recently, we're seeing yields that are up half a percentage point or more relative to where they just were six weeks ago. So I think the recent increase has presented an opportunity for investors who maybe thought they missed their chance. 

Now, we had our guidance earlier this year and last year to extend maturities and lock in higher yields with more certainty. While we're not as excited about that guidance now, we still think it can make sense in moderation, and especially for investors who might have too much cash or short-term investments. I think this is an important point. When you think about a diversified portfolio, you can look at three key asset classes, to oversimplify it, but three key asset classes of stocks, bonds, and cash. And we're finding that a lot of investors are holding elevated levels of cash right now. Now, that can make sense for some investors based on what their financial plan calls for, but we find that a lot of investors have money and cash that probably should be earmarked for bonds. And cash investments is a very short-term strategy, and if you have a lot of those short-term investments, we do consider kind of moving them out and locking in what we think are attractive yields and locking them in with more certainty, rather than facing reinvestment risk as the Fed continues to gradually cut rates. 

And then finally, we still favor high-quality investments right now. I focused on investment-grade corporates earlier. We think it makes sense to take risk if you're being compensated well for it. But that's not really the case today with a lot of the lower parts of the market. So for now, we would focus on high-rated, investment-grade-rated bonds, and then just consider the riskier parts in moderation. 

MIKE: Well, great conversation as always, Collin. You have a great ability to make what is, for a lot of investors, a mysterious part of the markets, make it really accessible and understandable and offer some great practical advice. I just want to thank you so much for making the time to talk to me today. 

COLLIN: Well, thank you so much for having me. It's always great to join. 

MIKE: That's Collin Martin, fixed income strategist at the Schwab Center for Financial Research. You can follow his work, along with the rest of Schwab's great fixed income team, at schwab.com/learn. 

Well that's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks, when I'll be sharing my reactions to the election and the implications on the key policy issues going forward.

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 For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.

I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, keep investing wisely and, most importantly, don't forget to vote!