This means many Americans may be noticing a decline in the fixed income portion of their portfolios this year, reflecting the decline in value of previously issued bonds on the secondary market. So while it was a great year to buy new issues of bonds directly, popular bond funds found in 401(k) retirement accounts are down for the year including American Funds Bond Fund of America (ABNFX), Baird Aggregate Bond (BAGSX), and Dodge & Cox Income (DODIX).

What to do
This could have you wondering if you should sell those bond indexes or change how you allocate future investments. Financial planners generally advise investors against doing anything drastic. In fact, forecasts of a looming recession could bode well for investors’ bond holdings. That is because the forces that drive down bond prices when interest rates go up, work in reverse when they go down.

“I wouldn’t be making decisions based on the last two years of bond performance,” says Eric Roberge, founder of the Boston-based financial planning firm Beyond Your Hammock. “In this case, you could argue that bonds are well prepared to do relatively well now that they’ve gone through what can be described as a big reset.”

Expectations the Federal Reserve may be close to done with its interest rate hikes may mean bond yields have reached their top. Rate cuts could be getting closer, and that could trigger a recovery for bond funds, Lammer said.

Chasing yields
Laura Mattia, chief executive of Atlas Fiduciary in Sarasota, Florida, said the biggest mistake she sees clients make with bonds is chasing yield, especially with corporate bonds. Recently elevated yields and low prices have made some investors think they can use bonds to generate the same returns that they might get from stocks, but with lower risks. There are a few problems with that assumption, however.

First: Higher yields can be a sign a bond investment or fund is too risky for the average investor. This is especially the case with companies that are in distress. In order to attract investors, they need to offer higher yields. But this reward comes with the risk that a company may go under and end up unable to pay back investors anything at all.

Second: Some bond yields change over time, particularly if they are linked to inflation.

“I bonds were really popular for a while when their interest rates were almost 10%,” said Dennis Nolte, a financial consultant with Seacoast Investment Services in Winter Park, Florida. “A bunch of people read the articles and put their $10,000 into I Bonds online and didn’t realize that the interest rate moves every six months.”

Now I bond interest rates are sitting at 5.27% and investors, and investors not only must hold I bonds for at least a year, but will lose interest from the prior three months if they cash them in before five years.

Third: Yields mask tax implications. Corporate, government and municipal bonds all face different liabilities. Income from corporate bonds is usually taxed at all levels; government bonds only at the federal level; and municipal-bond income is generally untaxed at the federal and state levels, depending on where you live. This means that a corporate bond with a high yield may actually bring an investor lower real returns versus a (possibly less risky) municipal bond once taxes are taken into account.