MIKE TOWNSEND: If you are a regular listener to this podcast, you have heard me say that I find bonds intimidating. I do hold bond funds, more out of a sense of obligation than enthusiasm. I understand the principles of asset allocation and a diversified portfolio, and that bonds play an important role in that. But I can't tell you much about the bond funds I own, beyond the fact that they were recommended to me by my financial advisor.
But in recent years, bonds have been in the news regularly because they have been on quite a wild ride. 2022 and 2023 saw the worst two-year performance by bonds in a century or more. Rising inflation, followed by the Federal Reserve's aggressive rate hikes, wreaked havoc in the bond market. Articles were being written about whether the traditional 60/40 split between stocks and bonds in a portfolio was dead, or at least needed to be re-evaluated.
But since roughly last October, bonds have generally offered attractive returns. So what does the rest of 2024 look like for the bond market? Will these good rates hold? Will they revert to how they performed for the 40 or so years before 2022—meaning inversely to equities? How should investors be viewing bond market opportunities right now and for the mid- to longer-term?
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 just a minute, I'm going to welcome two of Schwab's bond market experts, Cooper Howard and Collin Martin, to give us a real education about how the bond market works, how investors can navigate this important but confusing market, and where the opportunities are to diversify your portfolio.
But first, here are my three things to know in Washington right now.
Number one, both the House and Senate are in recess this week for the Presidents' Day holiday, and that's probably a good thing, given that the dysfunction on Capitol Hill has reached astonishing levels, and tensions are running very high.
Last week, the Senate easily approved a $95 billion aid package that includes more than $60 billion for Ukraine, $14 billion for Israel, more than $9 billion in humanitarian aid for civilian victims in Gaza, Ukraine, and other hotspots, and about $8 billion for Taiwan and other Asia-Pacific allies to combat the influence of China in the region. The final vote was 70 to 29, a strong bipartisan showing.
But the bill's fate in the House of Representatives is much more uncertain. House Speaker Mike Johnson has indicated that he will not bring the bill up for a vote because not enough Republicans support it and because the bill does not include any of the much-discussed border security provisions, border security being a much higher priority for many Republicans than funding a foreign war. But earlier this month Republicans rejected the border security provisions that had been negotiated by a bipartisan group of senators. Now there is no clear plan for how the House will proceed on either the foreign aid package or the border issue.
The new speaker of the House is working to corral fellow Republicans into a cohesive group with a clear strategy and legislative goals. But it appears to be an uphill battle that has led to a series of embarrassing failures, including votes being defeated on the House floor, votes that were announced and then canceled when leaders realized they did not have enough support to pass, and plenty of internal fighting among Republicans.
And all that sets the stage for the second big thing to know: When Congress returns to Washington next week, they will immediately be facing the first of two deadlines to keep the government open and operating. Congress still has not passed a single one of the 12 appropriations bills that fund every federal agency and program. That was supposed to be done by the end of last September. Instead, the government has been funded by a series of short-term extensions of last year's funding, known as "continuing resolutions." Congress passed one last September, a second in mid-November, and a third in mid-January. Now the new deadlines are upon us.
Funding for five major agencies runs out on March 1. Funding for the rest of the government expires a week later, on March 8. Republican leaders in the House have vowed not to pass another short-term extension, but that may be the only choice they have. Since the chances of passing all of the appropriations bills through both the House and Senate in the next couple of weeks is, well, extremely low, the only alternative to another short-term extension is a government shutdown. A shutdown in the next couple of weeks would seem to only add to the narrative that Congress cannot get the most basic elements of governing right, but I can't discount the possibility that a shutdown may happen. As you've heard me say before, historically, government shutdowns have not been big market-moving events. But extended shutdowns can start to have broader economic implications, so I'll be sharing updates on how all this plays out as the calendar turns to March.
And third, the last couple of weeks have seen some striking comings and goings in the House of Representatives. Democrats were able to flip a seat in a special election last week in New York, where former Rep. Tom Suozzi won the race to replace former Congressman George Santos, who was expelled from Congress in December. Once Suozzi is sworn in next week, the Republican majority will narrow to 219-213, with three more special elections coming later this year to fill vacancies. That means that Republicans can afford only two "no" votes and still be able to pass a bill on the House floor. That is going to be a difficult path.
While Suozzi will make his return to Congress next week, there have also been several notable retirement announcements that further the perception that Congress is becoming an increasingly unpleasant place to work. Congresswoman Cathy McMorris-Rodgers of Washington state, the Republican chair of the Energy and Commerce Committee, announced that she would not run for re-election after nearly 20 years in Congress. Rep. Mark Green of Tennessee, the Republican chair of the Homeland Security Committee, also announced that he would not return to Congress after this year. In his announcement, Green said that Congress was "broken beyond repair." What's particularly notable about the retirements of McMorris-Rodgers and Green was that they are chairs of powerful committees. Republicans in the House are limited to six years as a committee chair by an internal party rule, but neither McMorris-Rodgers nor Green have reached that limit—and yet they still decided to walk away. They are the fourth and fifth House committee chairs to announce that they are leaving Congress at the end of this year.
Also announcing that he would not be running for re-election was Wisconsin Republican Mike Gallagher. Gallagher, just 39 years old, has been in Congress for eight years and was seen as something of a rising star. But he was one of just three Republicans to oppose the impeachment of Homeland Security Secretary Alejandro Mayorkas and was taking significant blowback in his home district for that vote. He announced days later that he would not run for re-election.
There is growing concern in Washington that the dysfunction on Capitol Hill is driving members of both parties to retire, sapping the chamber of experience and expertise. The recent announcements mean that 51 members of the House who were elected in November 2022 are not planning to return to the chamber, either because they are running for another office, retiring, or have already resigned. Many of the retirees are saying that they no longer feel that serving in Congress is a productive use of their time and energy, that they can better focus on policy priorities by serving in some other role. And those who are planning to stay in Congress are concerned. Last week, in a CNN interview, Republican Congressman Chuck Fleischmann of Tennessee said that "there is absolutely concern over a loss of knowledge, a loss of seniority, … a loss of civility."
It's an important trend to watch because there are big issues looming that will require leadership and compromise in Congress, including the expiration of the 2017 tax cuts next year, the impact of trillion-dollar budget deficits, another debt ceiling battle in 2025, and fundamental structural problems in Social Security and Medicare—just to name a few. Whatever your political perspective is, a legislature that cannot manage the basic tasks of governing is bad for everyone, including the markets.
On my Deeper Dive today, we're going to focus on the bond market. Of course, there are plenty of investors who are fully engaged with bonds and actively trade them in their portfolios. But judging by the questions I get when speaking with clients, there are a lot of investors who see bonds as nothing more than a necessity for a balanced portfolio. They just sit in our portfolios while we're busy tracking our equity holdings, and for many years that seemed to make sense.
But after a rough ride for bonds over the last couple of years, times have changed again, and now bond investors are getting real returns, not just a hedge in their portfolios. Those greatly improved returns, however, come with challenges, like knowing where to get the best balance between returns and risk or how to maintain good returns in a volatile market.
So to help us understand today's bond market and its challenges, I'm pleased to welcome two guests, Collin Martin and Cooper Howard. Collin and Cooper are both fixed income strategists with the Schwab Center for Financial Research, and both are CFA® charterholders, which stands for Chartered Financial Analyst®, one of the highest designations for professionals in the investing world. They specialize in different areas of the bond markets, which is why I thought it would be great to have them on together to get their insights on where the bond market is heading, what's driving the movement, and how and when investors should incorporate bonds into their portfolios—both as a hedge against volatility and to capture solid returns. Collin, Cooper, thanks to you both for joining me today.
COLLIN MARTIN: Hi, Mike, thanks for having us.
COOPER HOWARD: Thanks for having us, Mike. I'm happy to be here.
MIKE: Well, I want to start really simple. The fixed income space is filled with a lot of confusing lingo. I mean, you can start with the name itself, fixed income. Both of you have those two words in your title, but for a lot of investors, I think it conjures up images of retired people living on fixed incomes, waiting for that Social Security check to arrive each month. I'm betting that's not quite how you see it. Right, Collin?
COLLIN: That's right, Mike, and we do find there's a lot of confusion around the fixed income markets. I think it's good to step back and explain what they are. When we talk about fixed income investments, we're really talking about bond investments. Those two terms are synonymous the way we think about them. So Cooper and I are fixed income strategists. We could also be called bond strategists. We find that a lot of investors don't think they really know how bonds work or how fixed income works.
But we think that they're similar—they share a lot of similar characteristics—to certificates of deposits, or CDs. So the good news is, if you understand how a CD works, you probably have a good idea of how a bond works. Now at its heart, at its soul, a bond is really just a loan. When you buy a bond or invest in a bond, you are lending to an issuer, and there's usually a rate of interest that's paid. Usually that interest is fixed, and that's why it's called fixed income.
Now there's a number of key terms that get thrown around a lot. Maybe that adds to the confusion in the fixed income market, so I'll kind of go through a few of those. The first is par value. That's how much you are lending to a corporation, a municipality, a government, for example, and then therefore what you'll get back. That's how much you'll receive at maturity. Second term is maturity, or your maturity date. Most bonds have stated maturity dates, and that's really great for planning purposes. I think that's a way that bonds and fixed income are incorporated to portfolios. And there's also the rate of interest that you earn on the bond, on that par value. And then finally, there tend to be credit ratings for most bonds. That's a reflection of the credit worthiness of the issuer. So if you have a high credit rating, that usually means the issuer is credit worthy. If you have a low credit rating, usually there is greater risk with that issuer and maybe more risk that you won't receive those timely interest and principal payments.
COOPER: Collin, I'd add you hit on a good term of the interest that you expect to receive. And I think that this is a very big term that can create a lot of confusion. We often hear terms like what's your yield, what's your interest, what's your coupon, and they're three different things. So I want to break that down a little bit. If you look at the coupon, this is the stated amount that that issuer agrees to pay you. So for example, if it's a 5% coupon and you were to buy a $1,000 bond, then you would expect to receive $50 per year, or $25 every six months. Now, your yield might be different than that coupon because if you were to buy that bond at a price below its maturity value, you're going to get a little bit in terms of the price fluctuation, and you're going to get that $50 per year. So that's where your yield or your interest comes into play. I think the other thing that can also add confusion to the bond market is a term that we often use, or we look at, and it's called the yield curve.
And all that the yield curve is, is a visual representation of a yield relative to a time to maturity. So it's something that can be as short as three months, all the way going out to 30 years. And us bond folks tend to watch that quite a bit. There's a lot of different reasons why we look at it. I won't go deep into the weeds on it, but it gives us signals potentially of the direction of the economy or kind of what the market's betting on. So there's a lot of reasons why we look at something like that. But at the end of the day, it's just a quick snapshot of different yields relative to different maturities.
MIKE: Really helpful to get those baseline terms. Let's talk about the market itself. I've heard you both say that there isn't just one bond market; there are lots of bond markets. And I think that adds to the confusion. You've got munis versus corporates. You've got high yield bonds. You hear terms like "one year," "two year," "10 year." So let's do a quick crash course on the fixed income market and make sure listeners understand the different types of bonds. Collin, why don't you kick us off?
COLLIN: Well, Mike, I think you kind of hit the nail on the head that there are a lot of different types of bonds out there, and that's where confusion stems from. If you're an investor looking to enter the bond market or consider investing in bonds, where do you even start? Because there's Treasuries, which are issued by the U.S. government. There's municipal bonds, corporate bonds. There's international bonds issued by foreign governments, both developed market and emerging markets. There's mortgage-backed security. There's different credit ratings, highly rated bonds, low-rated bonds, so it is really confusing.
Now one area that I focus on at Schwab with the Schwab Center for Financial Research is the corporate bond market. Corporate bonds are bonds that are issued by corporations, and they can issue debt really for any number of reasons. A company might want to build a new plant, maybe they're looking to buy a company, so they need to issue debt to get that money to buy the company, or maybe they want to refinance debt that's maturing soon. Corporate bonds have various levels of credit worthiness. I mentioned this earlier, Mike, that there are credit ratings for most bonds. And credit ratings start as high as AAA, and they fall as low as, say, single C. But what matters more within that wide spectrum is what's considered investment grade and what's considered high yield.
Investment-grade credit ratings are those that rank from AAA down to BBB, or more specifically, from AAA to AA to single A to BBB. And that's the investment-grade rating scale. If you're a corporation that has that kind of rating, usually it's a diversified company, has strong earnings relative to its debt, probably has relatively stable cash flows. And when we look at what the risk of those issuers are, it's usually low or moderate risk. Then there's also the high-yield spectrum, and that includes bonds that have credit ratings of BB or below. Now high yield goes by a number of names. Maybe you've heard them called junk bonds or sub-investment-grade bonds. These bonds come with more risks because the issuers might have more volatile cash flows. They likely have a lot more debt relative to their earnings. And then when we look at that whole corporate bond universe, we earn different levels of yield or additional yield relative to those credit ratings. That additional yield that investors earn on corporate bonds is called a spread. So if you look at a corporate bond with, say, a five-year maturity, you'll start with what the five-year Treasury note offers because that's considered a risk-free rate, and then depending on the credit rating, investors will earn extra yield on top of that. So if you look at the investment-grade market specifically, on average, investment-grade corporate bonds offer about one percentage point more than comparable Treasuries.
And if you look at the junk market, or high-yield market, you can see extra yields of three percentage points, four percentage points, five percentage points, really depending on that issuer's credit rating and credit worthiness. And we look again at that high-yield market, those higher spreads and higher yields are meant as compensation because they are risky, and they do tend to default much more frequently than investment-grade issuers, which don't really default too often.
And then just to sum it up, Mike, for investors, I think it really depends on what your risk tolerance is when you want to consider these types of investments. Again, to talk about those investment-grade-rated corporate bonds, they have those ratings for a reason, a lower likelihood of default, a greater likelihood of getting your money back at maturity. So if you have a low or moderate risk tolerance, I think those are likely appropriate. And then when you look at high-yield bonds, or junk bonds, those have a lot of risk. You earn higher yields for those risks. But they do have a greater likelihood of defaults. That's something to consider, and you really want to be more of an aggressive investor so you can ride out those ups and downs.
MIKE: Cooper, what about your specialty, municipal bonds?
COOPER: So municipal bonds, Mike, they share a lot of similar characteristics with those of corporate bonds. So for example, they have similar maturities. They may go all the way out from as short as just one week to all the way as long as 30 years. They share similar credit ratings. On average, municipalities tend to be higher credit rated, or have higher credit ratings, than the corporate bond market. And I think that that's because of what is backing those municipal bonds. So these are bonds that are issued by cities, states, local governments, and they're usually backed by the taxes that those cities or states or local governments levy, or they're backed by user fees. So for example, think of something like a water and sewer utility district. We all pay our water bills. The water utility district may issue bonds to help improve their pipes or increase kind of their service area. And so oftentimes, because they are backed by what we would call an essential service, they tend to be very highly rated. Now, one of the other big differences between corporate bonds and municipal bonds is the tax treatment of that interest income that you would expect to receive. So a corporate bond is usually subject to federal taxes as well as state taxes. A municipal bond, on the other hand, is usually exempt from both federal taxes and then potentially state income taxes if you purchase it in your own home state. So to give an example of when this would be beneficial, because usually purchasing a municipal bond is more beneficial to an investor who's in a high tax bracket.
So let's consider a hypothetical example where you're investing in a brokerage account. Consider two different bonds. One is going to be a fully taxable bond that pays $100 of interest income. The other is going to be a tax-exempt bond, a municipal bond, that pays $70 of interest income. But that municipal bond, you don't pay taxes on it. So you don't pay federal income taxes on it.
So let's also consider two different types of investors. The first one's going to be in a lower tax bracket. Just for rounding purposes, we're going to use a 20% tax rate to make it a little bit easier. So in that fully taxable bond, if the investor in the 20% tax rate would invest in that, they'd pay $20 in taxes, and at the end of the day, they would keep $80. Compare that to an investor who was maybe in a higher tax rate.
Just again, for rounding purposes, let's use 40%. So they would pay $40 in taxes and keep $60. Compare that to the option of the $70 municipal bond that you're not paying taxes on. For that investor who's in that higher tax bracket, they end up with more money after considering the impact of taxes.
What's really important to consider here, Mike, is the impact that taxes can have on the amount of money that you keep at the end of the day. So if you're an investor who's in a higher tax bracket, then we really think that it could make sense to consider municipal bonds relative to comparable alternatives.
MIKE: Collin, you think a lot about taxes, too, in your consideration of the market. And I think a lot of investors are seeing that their older bond holdings are kind of down and they may still have losses in those bonds, which that may present an opportunity from a tax perspective. Been reading articles about this recently in places like The Wall Street Journal, which recently did an article about how bond funds themselves have lots of losses embedded in them. But how do you think about the tax consequences of bonds?
COLLIN: Well, that's right, Mike. Bond values are generally still down from their peak values. And I think a lot of investors might not think of their bond holdings as a way to harvest losses, to offset gains, or something like that. So when you look at different parts of the market, for example, the stock market has been rising lately, investors might not have losses there. Maybe they have some gains. Maybe they could use some of the losses with their bond holdings to offset potential gains if they have them.
Now keep in mind, especially with individual bonds, if those values are down, those are temporary declines right now. You can simply hold to maturity, and, barring default, get your full investment back.
Every investor's situation is different. So I think it always makes sense to kind of work with a tax professional and make sure you're making the best moves for you.
MIKE: Let's shift gears a little bit to the best entry point for investors into the bond market. Take me, for example. I'm at the midpoint of my life. I have bonds in my portfolio because I understand that they're an important part of a broadly diversified portfolio. But as I mentioned at the top of this episode, I could say honestly, never bought or sold an individual bond in my life. All of my fixed income investing has been through bond funds either in my retirement accounts or because they were recommended to me by my financial advisor. And I think I'm probably representative of a broad swath of investors in that case. But I'm pretty sure that you both see bonds in kind of a different light. So talk a bit about what could be a better way to think about bonds and get them into our portfolios. Maybe what I'm really asking here is, are bond funds enough, or am I missing out because I'm intimidated by the idea of researching and buying individual bonds.
COOPER: Yeah, Mike, I don't necessarily think that you're missing out by buying bond funds versus individual bonds. So maybe because you've never bought an individual bond doesn't mean that you've never owned an individual bond because a bond fund is just a portfolio of individual bonds. So they work similar to one another and can provide similar diversification benefits to one another. But I think that there's some key differences between the two.
And really which one makes most sense for an investor comes down to those key differences. So we're not going to recommend, oh individual bonds are better than bond funds or bond funds are better than individual bonds
And it really depends on your own personal preferences and what key characteristics you're looking for.
So, for example, by buying an individual bond, you know exactly who you're lending that money to. You know what interest rate, or coupon, they're expected to pay you back. You know the price that you're expected to receive. So you can follow that, and kind of that certainty might be a little bit of a benefit for an individual investor. Now the flip side is that if you are buying individual bonds, usually you have to have a larger dollar amount to get adequate diversification. So we usually suggest at the Schwab Center for Financial Research buying at least 10 different issuers with differing credit risks. That can be difficult for some individuals to buy 10 individual bonds. Now, when you purchase a bond fund, usually for every dollar that you invest in a bond fund, it's spread out between either hundreds or thousands of different individual bonds. That diversification piece tends to favor a bond fund over individual bonds.
However, bond funds don't have a stated maturity value when you would expect to receive it back. So they do fluctuate in prices, which can be a downside for some individuals because they don't like to have that fluctuation in their overall bond portfolio.
COLLIN: I'll add to that—I think Cooper laid out some really great points. What I think matters also is investor psychology, and how do you handle price fluctuations, because we've talked about prices changing in the secondary market, prices and yields moving in opposite directions. If you hold a portfolio of individual bonds and their prices fall, you can sort of look through those price declines as temporary, knowing that you're going to receive a certain amount at maturity. You don't really get that benefit with bond funds because they don't have those stated maturity dates that Cooper mentioned. So I think it comes down to how you look at those losses, and are you able to kind of look through them, or if with a bond fund, do you trust that you're holding for the long run, and over time, the manager's going to be managing those positions and taking advantage of current market conditions. I think that's important. And there are strategies that are kind of a blend of both. There's something called a separately managed account where investors can actually hold the individual bonds themselves, but it's managed by a professional bond manager. So that's something to consider where it's a little bit of both strategies.
MIKE: Well, this is a great foundation of bond basics, but let's talk about how the bond market is actually performing. 2022, really tough year for the markets generally, but a particularly tough year for bonds. By some measures, the worst year for bonds ever. But I also think it shook a lot of investors' confidence because it's an old investing axiom that stocks and bonds usually move in opposite directions. So what has happened over the last couple of years, and what's your perspective on bonds in 2024?
COLLIN: I'll kick it off, Mike. I'll go over the "what happened" idea, because we know that caught a lot of investors off guard. If we go back to 2022, specifically, the Bloomberg U.S. Aggregate Bond Index, which is really a benchmark bond index for U.S. high-quality bonds, it suffered its largest decline, its worst total return since its inception. And we look at total returns, that comprises of price changes as well as the interest income you receive. Now, if we look back to 2022, it was a really tough year for a few reasons. The first is the low starting yields. If we look at the Agg specifically, the average yield of that index was close to 1%, very low compared to its 40-plus-year history. And with low yields, that's just less income, low income that investors were receiving from funds that followed an aggregate-bond-index-type strategy.
But more important was the decline in bond prices that we saw in 2022. And that stemmed from the really high rate of inflation. To slow inflation, the Fed aggressively raised interest rates. And when the Fed hiked rates, the yields on most bond investments rose as well. And that's a bad thing for bondholders because bond prices and yields move in opposite directions. If yields on newer bonds offer higher yields than what's available in older bonds, the prices of older bonds tend to fall to compensate for the lower interest rate they pay. For example, if I owned a bond with a 2% interest rate, but investors could get a 5% interest rate with a new bond, and then I wanted to sell my bond in the secondary market, I'd probably have to sell that bond at a discount to make it more attractive. So that's why the rise in yields in 2022 pulled bond prices down so much.
And then going back to that main first point about low yields, with such a low starting yield and low income payments, there wasn't much to help offset those large price declines that we saw.
COOPER: So there's two primary reasons why we don't think that 2024 is going to be as difficult of a year as 2022 was. The first is that starting yields are much higher. So remember that your total return for fixed income is made up of changes in prices plus the interest income that you expect to receive. Today, that interest income is much higher than it was back in 2022. So that can help provide some sort of a buffer against those changes in prices.
And prices move opposite the direction of interest rates. That brings me to my second point of why we don't think that 2024 is going to be as difficult of a year as 2022. And that's because we expect that the Fed is done hiking interest rates for this cycle. More importantly, what the market is looking at is how many rate cuts are we going to get, and what is the timing of those interest rate cuts?
MIKE: I want to dive into that conversation about the Fed just a little bit more. Obviously, the bond market, very sensitive to the Fed, not just interest rate policy, but also because the Fed holds so many Treasuries in its portfolio. So anytime it makes adjustments to that portfolio, it can have big implications for the bond market. It feels, Collin, like the Fed is always sending these signals to Wall Street. How do ordinary investors understand these signals?
COLLIN: I think what's most important for investors is the direction of Fed policy. And what I mean by that is are they really raising rates or lowering rates, or are they tightening policy, or are they easing policy? Let me back up and talk about the Fed real quickly, what the Fed actually does. The Fed has a dual mandate of price stability and maximum employment. And when we talk about price stability, that's another term for inflation. we've seen inflation skyrocket in 2021 and '22, and it's since come down. When it was rising so much, the Fed raised rates to slow things down a little bit. When the Fed raises rates, it makes it more prohibitive for consumers, for individuals, for businesses to borrow. And if borrowing slows down, that can slow down growth, and it can therefore slow down inflation. And that's really why we saw rates rise so much in 2022 and then 2023. What matters for investors really is that direction. So when the Fed is tightening as they had been, that usually pulls yields up. So that's something to consider if you're going into bonds, are bond yields rising or falling? And if the Fed is easing, like we expect later this year, we think yields should generally decline. And I think that's really important right now because we've seen yields rise so much, we've seen them rise to levels that we really haven't seen in a long time, but if the Fed does begin to cut, that means those yields could fall. We've already seen some yields fall, but it could mean short-term yields could fall as well. So it's something to be cognizant of as you're looking to boost the income in your portfolio, or you're considering fixed income investments, when the Fed does begin to cut rates, that could pull yields lower down the road.
MIKE: The other piece of this Cooper is the Fed's balance sheet, something that we always hear mentioned. Maybe you could explain what the Fed's balance sheet is and how the Fed uses it.
COOPER: Yeah, so the Fed's balance sheet, Mike, is just another tool that they have in their toolbelt. So the Fed can purchase Treasuries and mortgage-backed securities to help boost the amount of money that's in the system and kind of spur growth, and maybe if we're in a low inflationary environment, like we saw coming out of 2008, kind of spur the economy along. And the Fed has done that recently, but now that things are looking better going forward, they've started to slow the amount of Treasuries that they've purchased, and they've stopped purchasing Treasuries and mortgage-backs securities. Instead, they've allowed Treasuries and mortgage-backeds to roll off their portfolio and mature into the market without actually purchasing new bonds to replace those. And that ultimately, Mike, just influences the amount of money that's in the system. And it kind of acts, Mike, like gasoline in a combustion engine. So the more gas that there is, helps kind of spur growth along. Now the Fed's balance sheet, it's already dropped by about a trillion dollars to the point where it's roughly about 28% of GDP. That's still very elevated compared to historical averages. If you look back prior to the 2008 credit crisis, it was about 6% of GDP. So the expectation is that the Fed will likely slow the amount of quantitative tightening that we've seen so far but, it is just another tool that they have in their toolbelt to help influence the direction of monetary policy and interest rates.
MIKE: Of course, the Fed is not the only agency here in Washington that has a big impact on the bond market. Treasury Department issues Treasury bonds to raise money to cover the government's debt, and right now we've got plenty of that. I find it interesting that the way these issues come to the market is through frequent auctions, which is, I think, a part of the Treasury scene that most investors don't really think about. So how do these auctions work, and what can we learn about the state of our economy based on what happens with the auctions?
COLLIN: Well, this has been a popular topic lately, Mike, and keep in mind that it's the presence of deficits that results in the existence of government bonds. If the government is spending more than it's taking in, it needs to fill that gap with new bond issuance. Now, on the topic of auctions, the Treasury has regular auctions all the time, literally every week for Treasury bills. Treasury bills are Treasury securities that mature in 12 months or less. And then slightly longer-term notes or bonds, say a five-year, a 10-year, a 30-year, for example, they're auctioned regularly, but less frequently than Treasury bills. Now when there is a Treasury auction, it comes down to supply and demand. Market participants, investors, submit bids, but it's really them submitting what yield they would like to buy those Treasuries at. Now keep in mind that there are already existing Treasuries in the secondary market. So when the Treasury is auctioning a new 10-year Treasury note, investors can look at what a current secondary market Treasury note is offering, and then they'll submit a bid, or submit a yield, based on that. And the success of an auction is usually based on the number of investors that are participating. Ideally, we want a lot of people who are coming in to buy Treasury securities. And there's really a push and pull. Treasury wants to issue securities at the lowest yields possible to keep government interest expense down, but investors, they'll want higher yields. And when an auction's done, a Treasury is going to sell the bonds to those who submit the lowest yields that are out there.
Now there's a lot of questions lately about the rising supply because of the deficits we've seen, and that could pull Treasury yields higher. And let me explain it this way, Mike. Let's say the Treasury is auctioning a 10-year note, and they're auctioning $40 billion. But when the auction comes around, there's only $30 billion worth of bids. Now that doesn't really happen. Usually auctions are oversubscribed. But in this example, let's assume that there's not even enough demand out there to fill that auction. Well, in that case, yields would have to move higher to attract new investors.
So let's say I wasn't interested in buying Treasuries, but suddenly they need to sell them, and yields are going … maybe I'd consider buying those Treasuries at a higher yield. So that's the concern that a lot of market participants have had around the rising debt, the rising deficits, and the rising supply of Treasuries, that it can pull Treasury yields significantly higher, and that could have a number of negative consequences for our economy. It would mean more interest expense from our government that we wouldn't be able to spend elsewhere. But we've looked at this over time, Mike, and this isn't an endorsement or anything of current fiscal policy, but we've looked at the relationship over time between the size of the U.S. debt, the debt growth, the size of the deficits, the size of Treasury auctions, and we haven't found a relationship between any of those factors and what it means for Treasury yields. What we have found is that growth expectations, inflation expectations, and Fed policy are really the key driver of Treasury yields. So the debt is high, it's been growing, maybe it would be an issue down the road, but for now, based on what it means for Treasury yields in the here and now, we just haven't found much of a relationship over time.
MIKE: Well, Collin, Cooper, you have done an amazing job at explaining how the bond market works and what investors should be paying attention to. I certainly have learned a ton from this conversation. So let me wrap it up by just asking both of you: What do you think investors need to know right now about the state of the bond market and where there could be opportunities?
COOPER: I think one of the important things that listeners should take away is that yields are attractive right now. If we look at the Treasury yield curve, Treasuries of all maturities yield above 4% right now. So if we were to go back just a few years ago, that wasn't the case. You were looking at Treasuries that yielded 1%, even less than that, so much lower.
So if we were to ask many of our investors, hey, if I can offer you a Treasury bond of 4%, would you take that? When it was an investment that was only 1%, I think a lot of our investors would take that. So today we're at that point right now. The other point that I would highlight is that you really don't have to take on that much added credit risk to get those attractive yields. And again, that's something that wasn't the case just a few years ago.
So for an example, let's look at a high-yield corporate bond. Collin had mentioned some of those. Those are bonds that are issued by corporations that have below-investment-grade, or junk, ratings. An index of those high-yield corporate bonds back in 2021 yielded 4%. So you were investing, if you wanted to, investing in bonds that had substantial amount of credit risk. That's not the case today. Today you can invest in a Treasury bond that's backed by the full faith and credit, the taxing authority, of the U.S. government that yields above 4%.
COLLIN: And Mike, I'll add that I think it's just great for the listeners to be listening to this podcast right now. You asked what investors need to know right now about the state of the bond market. I think it's important to just have a better general understanding of the bond market, because we find when we meet with investors, when we meet with clients, that there is that gap, that there's a lot of confusion coming from the bond market. So in order to follow our guidance, to actually consider fixed income investments in your portfolio, you have to have a better understanding.
Just listening to this is a great first step, and then I'll echo everything Cooper said. Yields are attractive now, and if you've been waiting for higher yields, they're here.
MIKE: Well, Collin, Cooper, great advice. Thanks so much to both of you for making the time to talk to me today and to demystify the bond market a little bit.
COLLIN: Thanks, Mike.
COOPER: Thank you for having us, Mike.
MIKE: Thanks again to Collin Martin and Cooper Howard, fixed income strategists here at Charles Schwab. You can follow their latest commentary 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. Take a moment now to follow the show in your listening app so you don't miss an episode. And if you like what you've heard, leave us a rating or a review—those really help new listeners find the show.
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, and keep investing wisely.
