As rates rise, the antidote to volatile stocks could now be bonds. Here's why.

While many wonder whether the stock market has seen its lows this year, there’s a rebound happening in the bond market that people might be missing, analysts say.

Bonds usually rise when stocks fall, which is why they’re often used as a counterbalance to stocks in a portfolio. That didn’t happen this year amid soaring inflation and uncertainty over interest rates and the economy.

Bonds registered the worst first half “since either before the Civil War or George Washington was president, depending on the source,” Vanguard says.

But that has changed, and the message is clear: the economy is overheated and high inflation needs to be cooled with much higher interest rates that will stick around, Federal Reserve Chairman Jerome Powell said last summer.

That’s giving bonds the green light to start performing better.

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Why did bonds perform so poorly?

When the Fed held interest rates near zero in 2021 to goose the economy, cash and bonds also paid nearly zero interest. Compounding that was the Fed’s failure to recognize the economy was overheating and inflation was on the rise. Inflation hurts bonds because it erodes their return, meaning the inflation-adjusted returns were negative.

That gave rise to the TINA, or There Is No Alternative, play – investors had no choice but to pour money into equities to get a decent return.

What has changed now for bonds?

The Fed is now fully focused on fighting inflation and has embarked on an aggressive rate hiking cycle. It has boosted its short-term benchmark fed funds rate by 3%, with each of the last three rate hikes by a supersized three-quarters of a percentage point. The latest one was just Wednesday, and the Fed's median economic projections now see fed funds at 4.4% by year-end and up at 4.6% next year.

While rising interest rates can hurt companies by making borrowing more expensive and consumers buy less of their wares and services, this is a boon for bonds, which has a market capitalization of about $40 trillion that dwarfs publicly traded stocks' roughly $30 trillion. Bond yields move up in step with the Fed’s rate hikes, allowing people to earn more on their bond holdings.

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How much more can you earn now on bonds?

Little can offset 40-year high annual inflation, but bonds could at least help you lose less right now with virtually no risk.

The S&P 500 stock dividend yield is around 1.5%, but the guaranteed one-year Treasury pays just more than 4.1%. The S&P dividend yield is the weighted average of each listed company's most recent annual dividend divided by the current share price.

"If market volatility does continue, while equities may go down, bonds can act as a safeguard,” said Nilay Gandhi, CFP, senior financial adviser at Vanguard Personal Advisor Services.

Many analysts expect a recession in the next year, which means stocks may still have room to drop. “Equities could easily go down,” Craig Brothers, senior portfolio manager and co-head of fixed income at Bel Air Investment Advisors, said. “A true bear market is down 37%.” Year-to-date, the S&P 500 is down around 19%.

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Are US Treasuries the only bonds to consider?

No.

U.S. Treasuries are the safest because they’re backed by the U.S. government, which means no matter what – recession, war, inflation – Uncle Sam has you covered.

If you’re willing to take on a little risk, you can earn more on other bonds such as high-quality taxable municipal (munis) or corporate bonds, Brothers said.

But be careful with corporate bonds, he said. In 2020, many solid companies saw their debt downgraded when economies closed to slow the spread of COVID-19 and their businesses were negatively affected.

Those “fallen angels” might offer higher yields on their bonds, but Brothers warns the full scenario of the slowing economy, higher rates and elevated inflation has yet to play out.

“It’s best not to get too fancy,” he said. “You’re better off sticking with a high-grade portfolio, Treasuries, high-quality munis, taxable munis, high-quality corporates.” Many exchange-traded funds also offer safe ways to invest in bonds.

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What about inflation-adjusted bonds like I-Bonds or TIPS?

I-bonds are safe investments because you can’t lose money. For I-Bonds purchased through October, you’ll earn a fixed 9.62% interest rate, but note, the amount you can invest is limited to $10,000 per calendar year.

TIPS, or Treasury Inflation-Protected Securities, can be lucrative if inflation unexpectedly soars. Now that the Fed is laser-focused on squashing inflation and inflation is close to if not past its peak, TIPS may be less attractive as payouts shrink with inflation. While the interest rate on TIPS is fixed, the principal is adjusted twice a year based on consumer inflation.

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Who should invest in bonds?

Anyone who needs or wants a steady income with little risk, maybe – especially older Americans – should consider stashing money in bonds.

The 10-year treasury rate is at the highest level since 2010, and that higher rate means a higher return for anyone who holds them.

"For the first time in a long time, fixed income investors can actually celebrate the fixed income that they will receive in the future from the bonds they buy today,“ said Michael Batnick, managing partner at Ritholtz Wealth Management.

Medora Lee is a money, markets, and personal finance reporter at USA TODAY. You can reach her at mjlee@usatoday.com and subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday through Friday morning.

This article originally appeared on USA TODAY: Bonds could outperform stocks as rates rise and Fed fights inflation.