The Bond Market Is Doing Something That Hasn't Been Observed in Nearly 20 Years. Should Investors Be Nervous?

Interesting things are happening in the bond market, and "interesting" does not mean good news for bond investors. The yield on the 30-year Treasury bond recently rose to its highest level since 2007. As of this writing, the 30-year Treasury yield is about 5.172%, up about 65 basis points from its 52-week low.

Some bond investors are worried that U.S. government borrowing has become unsustainable, and are demanding higher yields on long-term government debt.

How nervous should you be about higher yields on the 30-year Treasury bond? At the moment: not very. Let's look at what's happening in the bond market and see what it might mean for your investments.

Many bond ETFs have delivered negative returns in recent years due to rising interest rates. Image source: Getty Images.

What's driving higher bond yields?

Just because the 30-year Treasury bond yield is over 5% doesn't mean there's going to be a government debt crisis or a recession or a stock market crash. There are a few other causes of higher bond yields that are not necessarily bad news for Treasury bond investors.

One reason for higher yields on Treasury bonds is higher inflation and strong economic growth. If bond investors believe that higher inflation (and higher interest rates) are here to stay, they will demand higher yields on long-term debt. This is a natural consequence of strong economic growth and inflation remaining stubbornly above the Fed's 2% target. It doesn't mean a debt crisis is coming; it might just mean that the bond market is repricing the risk of long-term debt.

Another cause of higher long-term Treasury bond yields is the recent increase in borrowing by major tech companies that are issuing hundreds of billions of dollars in corporate bonds to pay for artificial intelligence (AI) data centers. These corporate bonds from AI hyperscalers are adding supply to the bond market, driving down prices for long-duration U.S. government bonds.

Bond yields and bond prices go up and down

Bond yields are an interesting data point to follow in financial markets because they represent the price of money. U.S. Treasury bonds are defined as offering a "risk-free" rate of return, so when the yield on long-term U.S. Treasuries goes up, it can make some investors nervous. It's often seen as a sign that "bond vigilantes" are coming to punish the U.S. government for borrowing too much money, or that investors are losing confidence in the federal government's ability to pay its debts.

Unless you're a professional bond trader who's managing money for a large institutional investor, you probably shouldn't worry too much about short-term moves in the bond market. Bond yields and bond prices fluctuate for all kinds of complex reasons, just like stocks. Short-term volatility is normal, and it's better to stay the course than to make any knee-jerk moves out of fear.

How to invest in bonds now

Deciding which bond ETFs to buy for your portfolio depends on your risk tolerance and what you believe about the future. Long-dated bonds, like 30-year Treasuries, tend to be more sensitive to the risk of rising interest rates.

If you believe that the national debt is too high and interest rates are likely to go higher, you probably shouldn't buy long-term Treasury bonds like the ones held by the iShares 20+ Year Treasury Bond ETF (NASDAQ: TLT). This bond ETF has suffered from the past few years of rising interest rates. Its average annual total return has been negative (-8.18%) for the past five years.

A short-term bond ETF might be a better choice for many investors who are worried about rising interest rates. The Vanguard Ultra-Short Bond ETF (NYSEMKT: VUSB) is much less vulnerable to interest rate risk than long-term Treasuries. This Vanguard bond fund has delivered average annual returns (by net asset value) of 3.54% over the past five years and 5.25% over the past three years.

The bond ETF I own: Vanguard Total Bond Market ETF (BND)

Personally, I don't believe in buying lots of long-term bonds. I don't think 30-year Treasuries are the best choice for my portfolio. Instead, I buy the Vanguard Total Bond Market ETF (NASDAQ: BND).

This bond fund owns 11,451 bonds of all types, including Treasuries and corporate bonds, with a diverse range of bond durations. Like other bond ETFs, its performance has struggled in recent years, with an average annual return of -0.42% over the past five years.

But over the past 19 years, since the fund's inception in April 2007, BND has delivered average annual returns of 3.00%. Interest rates fluctuate, and some bond prices will go up or down, but over the long run, I believe the Vanguard Total Bond Market ETF is one of the best low-cost ways to include bonds in my portfolio.

Ben Gran has positions in Vanguard Total Bond Market ETF. The Motley Fool has positions in and recommends Vanguard Total Bond Market ETF. The Motley Fool has a disclosure policy.