Some central banks, notably those in Europe and Japan, have enacted negative short-term rates, charging banks for depositing money. The central banks are trying to stimulate economic growth by making it so cheap to borrow money that consumers and businesses will be prodded to spend and invest more.

And with prevailing interest rates so low, bond buyers have bid up prices so high that the yields of some bonds have dropped below 0% in the open market in more than 20 nations, including Japan, Germany, and Switzerland. (Bond prices and yields move in opposite directions.)

The impact on investors

Although negative rates have rarely appeared in the U.S. bond market (except for Treasury Inflation-Protected Securities), the downward pressure on yields worldwide has affected it. U.S. bond fund yields have fallen, and net asset values have risen sharply.

Bond fund investors may enjoy seeing their principal balances grow, but the shrinking yields are tempting some income-oriented investors to shift their money into riskier higher-yielding bonds or dividend-paying stocks.

As a result, those investors may be exposing themselves to more volatility than they’re prepared to handle.

What about people who hold international bonds to better diversify their portfolios?

Even though yields for many foreign bonds have sunk below 0% in their native currencies, it still makes sense for investors to hold international bonds, said Greg Davis, global head of Vanguard’s Fixed Income Group. Traditional currency hedging changes the equation for U.S. investors when foreign bond returns are converted into U.S. dollars.

“Through currency hedging, the yields of international bonds look more like domestic yields for U.S. investors,” Mr. Davis said. “With hedging, the ‘currency-adjusted’ yield on international bonds for U.S. investors has been positive, because U.S. yields have remained positive.”

What should investors do?

Many investors worry that bond prices have nowhere to go but down. Even if that happens, Mr. Davis said, long-term investors can ultimately benefit by reinvesting dividends into higher-yielding bonds, resulting in higher total returns.

Nonetheless, he said, “the days of above-average annual returns from bonds are probably over. We’re likely to remain in a low-yield, low-return environment for a while.”

It’s important to remember the primary role of bonds in a long-term portfolio, Mr. Davis said.

“The best reason for investors to hold bonds is not just for their regular income, but also for their role in cushioning a portfolio from the volatility of the stock market,” he said. “They’re a powerful diversifier. They’ve proven their worth over and over again.”

Notes:

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.

Currency hedging is the chance that currency hedging transactions may not perfectly offset a security’s foreign currency exposures and may eliminate any chance for a security to benefit from favorable fluctuations in relevant currency exchange rates.