With Treasury yields near multiyear highs, some investors are rethinking their portfolio strategies

While it might be tempting to turn to longer-term bonds that promise bigger interest payouts every six months, financial planners warn that investors putting all their eggs in one basket are more vulnerable to inflation and interest-rate volatility.

With U.S. Treasury yields on the rise, financial planners say they're seeing a growing interest in bonds, especially among investors looking to secure fixed income in retirement.

After steadily rising over the past five years from their pandemic-era lows, Treasurys with maturities of five years and longer have passed 5% in the past few weeks. Yields on shorter-term bonds have been rising, too: The 1-year Treasury bill BX:TMUBMUSD01Y had a 4.55% yield as of early Wednesday afternoon, while the 3-year note BX:TMUBMUSD03Y was 4.99%.

While it might be tempting to turn to longer-term bonds that promise bigger interest payouts every six months, financial planners warn that investors putting all their eggs in one basket are more vulnerable to inflation and interest-rate volatility. Investing in shorter-duration Treasurys or inflation-protected options such as TIPS or I-bonds can be a better place to start - but don't abandon your stocks, either.

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"For retirees, I generally prefer a balanced approach: more fixed income for stability, while still keeping equities for growth and inflation protection," said Joon Um, a certified financial planner at Secure Tax & Accounting in Hayward, Calif.

Why going all in on longer-duration bonds can backfire

Mel Mattison, an author and certified financial planner, said that if he were retired, he would be going all-in on 20-year Treasury bonds BX:TMUBMUSD20Y, which had a yield of 5.68% as of early Wednesday afternoon. Baby boomers typically start buying bonds around the 5.5% level, he said, and his thinking is that a 70-year-old with $2 million mostly in equities could move that money to 20-year bonds and earn $110,000 a year.

A guaranteed $110,000 in annual fixed income might sound ideal, but other financial planners warn it's not so simple. If an investor used a significant portion of their financial assets to lock in long-term Treasurys, they would be locking in their income, too. The semiannual interest payouts would stay the same for 20 years, while their expenses would vary. That's an important consideration for retirees, who often underestimate their long-term costs.

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"If short- to medium-term inflation runs even slightly above expectations for several consecutive years, it permanently lowers their real purchasing power," said Sean Lovinson, founder of the financial-planning firm Purpose Built in Moorestown, N.J. "A 5.5% nominal yield feels comfortable now, but over a 20-year horizon or even a 10-year [one], compounding inflation quietly destroys your lifestyle."

"A 5.5% nominal yield feels comfortable now, but over a 20-year horizon or even a 10-year [one], compounding inflation quietly destroys your lifestyle."Sean Lovinson, founder of financial-planning firm Purpose Built

Financial planners also raised concerns about the risk of bonds losing value if interest rates continue to rise - but Mattison isn't too concerned about that.

"I don't really think that there's potential for this economy to absorb 6%, 7% rates for a long period of time," he said. "I think that would induce a recession which would eventually drive down yields." Mattison also noted that cost-of-living adjustments for Social Security payments serve as an inflation hedge.

Even if rates don't go up, someone relying too much on fixed income could find themselves lacking the liquidity needed for an unexpected emergency expense, such as a medical bill or home maintenance. That emergency could force an investor to cash out early after interest rates have risen, meaning they would have to sell their bond at a discount on the secondary market and permanently lock in a loss.

There are also tax considerations. Interest from Treasurys is exempt from state tax but is taxed federally as income, which can push one's income above thresholds that trigger Medicare premium surcharges, Um noted. That wouldn't matter for retirees holding Treasurys inside a tax-deferred retirement account like an IRA, but any distributions would count as income.

Strategic ways to invest in bonds

There isn't a one-size-fits-all approach to buying bonds, but most experts agree it's a good idea to diversify. Investors should consider their liquidity needs, tax bracket and Medicare thresholds when determining their risk tolerance.

-- The three- to five-year "sweet spot": Most wealth managers advise keeping bond durations short - typically in the three- to five-year range - or spreading capital across a multiyear ladder. Keeping maturities short allows investors to capture elevated yields while preserving liquidity as bonds mature at par value.

-- Bond laddering: For investors who want to reap the rewards of longer-term bond yields, one common approach is to create a Treasury ladder, or a portfolio of Treasurys with maturities ranging from one to 20 years. "This would provide a similar income benefit yet it would reduce duration, liquidity and inflation risks, given the ladder would provide the retiree with interim liquidity as the principal of each maturity pays off at par value," said Vincent DeCrow, founder of Chicago-based RISE Investments. "If interest rates kept rising, the retiree could reinvest the proceeds from maturing bonds into new higher-yielding issues."

-- Look to TIPS and I-bonds: For those looking for bonds that offer protection against rising living costs, advisers often recommend Treasury inflation-protected securities (TIPS) or Series I savings bonds (I-Bonds), which have principal values that adjust automatically with the consumer-price index to preserve real purchasing power as inflation rises.

-- Don't abandon stocks: Even with a well-designed bond ladder, wealth managers emphasize that going 100% into fixed income at any age is a mistake that can leave an investor vulnerable. "The upside from equities could serve as a nice inflation hedge. For someone in their 70s, a balanced portfolio of 50% fixed income and 50% equities may be a good place to start," DeCrow said. "The equity portion of the portfolio would be more tax-advantaged if the retiree is in a higher federal tax bracket."