Until recently, there was a solid case to be made that investors should avoid fixed-income investments -- especially investors who still had decades left before retirement. After all, with long-term Treasuries paying less than 2% for most of 2020 and 2021, and the stock market performing well, it could be hard to justify accepting such low yields from a significant portion of your assets.
That has changed. Treasuries, corporate bonds, and CDs have become far more attractive. Even young investors are putting billions of dollars into fixed-income instruments.
However, interest rates are widely expected to start falling in 2024. There's some debate surrounding exactly when the Federal Reserve will start lowering rates, but most experts agree that it's likely to happen by mid-year.
If you've been on the fence about adding fixed-income investments to your portfolio, or simply want an investment that could produce both income and capital appreciation for the next few years (since falling rates mean higher bond prices), here are three exchange-traded funds (ETFs) to put on your radar.
1. Vanguard Total Bond Market ETF
If you're only going to buy one fixed-income ETF, it's tough to argue against the Vanguard Total Bond Market ETF (BND -0.06%). This ETF invests in a wide variety of bonds. It owns investment-grade corporate bonds, Treasury securities, and other types of fixed-income instruments.
The Total Bond Market ETF has a 4.33% yield as of this writing, which is a historically high level of income. Because price and yield have an inverse relationship, there could be significant price appreciation potential as rates fall.
This is a massive ETF with $315 billion under management and over 10,700 different bonds in its portfolio. It has a blend of short-, mid-, and long-term bonds, and the portfolio average is an 8.8-year maturity.
Since the ETF was formed in 2007, it has produced a 3% annualized total return for investors. However, take this with a big grain of salt -- throughout most of the ETF's history, interest rates were either historically low or rising. As rates gradually retreat from multi-decade highs, there's the potential for significantly higher total returns.
2. Vanguard Extended Duration Treasury ETF
As the name suggests, the Vanguard Extended Duration Treasury ETF (EDV 0.16%) invests in long-term Treasury securities. The average maturity of the bonds in its portfolio is nearly 25 years, and the ETF's current yield is about 4.6%, making it a great way to get a high level of current income.
Without turning this into too much of a math lesson, one important concept to know is that the market values of long-maturity bonds are more sensitive to interest rate fluctuations than shorter-term ones.
Think of it this way -- let's say that you buy a 30-year bond that yields 4.5%, which is close to the current 30-year Treasury yield as of this writing. This means that if you buy a $1,000 Treasury bond, you'll get $45 in guaranteed income per year for three decades. Now, if the market rate on a 30-year Treasury falls to 3%, a new $1,000 bond will only pay $30 per year. Since yours pays $45 per year, it is more valuable, even though it has the same face value.
This means that as interest rates fall, long-dated bonds have a lot to gain. And while it's generally not a good idea to buy fixed-income investments just because you think they'll go up in value, this ETF could be an excellent driver of total returns as interest rates gradually decline.
3. Vanguard Total World Bond ETF
The Vanguard Total World Bond ETF (BNDW) is similar in nature to the Total Bond Market ETF, with the key difference that it offers exposure to non-U.S. bonds as well.
This ETF owns about 17,800 different bonds. The average maturity is 8.8 years, and the ETF's current yield is 3.76%.
53% of the bonds it owns are from North America, with Europe (29%) and Asia-Pacific (11%) making up most of the rest. With a rock-bottom 0.05% expense ratio, it's one of the cheapest ways to get exposure to investment-grade international bonds in your portfolio.
What should investors expect in 2024 and beyond?
With rates largely expected to fall in 2024 and 2025, now could be a great time to lock in an elevated yield on your cost, and give yourself the potential for capital appreciation as market values of fixed-income instruments rise. While there's no guarantee that rates will fall (or that Treasury yields will immediately fall if they do), all signs point to a great entry point into bond ETFs in early 2024.
Matthew Frankel, CFP® has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard Bond Index Funds-Vanguard Total Bond Market ETF. The Motley Fool has a disclosure policy.
