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Next year has the potential to be one of the best years in a while for bonds.

Most investors should own some in their portfolio to help ride out tough stock markets – like the one we’re currently in – because bonds provide some ballast and safety.

Bonds have a par value of $1,000. The only way you won’t get paid $1,000 at maturity is if the company declares bankruptcy. Otherwise, no matter what is going on in the markets or the economy, you’ll get paid $1,000 per bond at maturity.

Now that interest rates have climbed up off the floor, bond investors can finally earn some real yield.

You can earn 5.5% by owning investment-grade bonds that mature in two years. Or 4.6% in a tax-free municipal bond with the same maturity. That’s a taxable equivalent of more than 6% if you’re in the 32% tax bracket.

And as the Fed continues to raise interest rates to fight off inflation, the yields should get even better.

Not only will you earn strong yields for the first time in years, but those bonds should increase in price once the Fed stops raising rates and starts lowering them.

Bond prices move in the opposite direction of interest rates.

It makes sense when you think about it.

If you can buy a bond for par value ($1,000) that yields 5%, when interest rates rise, no one will buy the bond that yields 5% if they can get a similar new bond that yields 5.5% because interest rates just went up.

So in order for that 5% bond to be able to be sold, the price has to come down to push the yield higher.

A bond with a 5% coupon pays out $50 per year ($1,000 x 5%, or 0.05 = $50). But you can’t just raise the interest on a bond the way you can raise a dividend. The interest rate is fixed. So the market will adjust the price of the bond so that the same $50 now yields 5.5%. In this example, the bond will fall to about $909 because $50 in interest divided by $909 is 5.5%.

Similarly, if rates drop, a bond with a 5% coupon will become more valuable because a new bond won’t have as attractive a yield. If a new bond pays 4.5%, then the 5% bond will climb to $1,111 because $50 divided by $1,111 equals 4.5%.

So investors who buy bonds next year will have the opportunity to earn strong yields. If the Fed eventually lowers interest rates, the value of the bonds will go up as well, and they can then be sold for a profit or held until maturity, collecting a high rate of interest.

I have a few rules for investing in bonds that I strongly recommend investors follow.

• Buy only bonds you plan on holding until maturity. If the price goes up and you have the chance to take a profit, you can, but you should feel very comfortable owning the bond until the maturity date and collecting your interest.
• Don’t watch the price of your bond every day. If you’re going to own a bond until maturity, who cares where it’s trading today or tomorrow? You know that when it matures, it will pay out $1,000. So if the bond drops to $900 or rises to $1,050, it really doesn’t make much of a difference. You’re probably not going to sell it anyway.
• Understand the risks. Bonds are very safe. Investment-grade bonds (rated BBB- or higher) have a default rate of just 0.1%. Junk bonds, or non-investment-grade bonds, have higher yields but carry higher risk. They have a historical default rate of 4.22%, with most of those occurring in bonds rated CCC or lower. So even if you buy a junk bond rated BB, you can earn a higher interest rate than you would with an investment-grade bond, without taking on too much risk. Unless you’re willing to speculate, I recommend buying bonds rated BB or higher to drastically decrease the likelihood of default.
• Keeping the maturities fairly short (for now). Don’t buy bonds with maturities more than five years out. It’s a good idea to have maturities staggered so that there is always some capital being freed that can be used for expenses or to invest in new bonds. So you may want to buy some that mature in two years and others that mature in three years, four years and five years.

I’m going to be putting more of my own money to work in bonds in 2023 to take advantage of higher yields and the safety that bonds provide.

I recommend investors do the same.

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