Bond investors have reason to be frustrated. As it is, they are willing to accept a lower total return than stock market investors by choosing safety and security over risk and return. The Fed has basically punished fixed income investors by keeping interest rates extremely low for a long time. The result is that you can’t simply pull a list of AAA government bonds, go out a few years, and expect a 5% yield to maturity. No sir, not anymore. What you can expect is something closer to 2%, or perhaps less. The more safety you require (think: treasury bonds) the less yield you can expect. I’m finding a great deal of difficulty building a bond portfolio these days which satisfies my bond investors in terms of risk, duration, and yield. The problem is that when I finally create a portfolio with a yield averaging 4%, I find my client is either taking on too much risk, or going out so far that they are locking in rates which they are soon to regret. So what are bond investors to do?
Like nearly everything in the world of investments, there is no perfect answer. If someone tells you there is, they are more than likely omitting some sort of risk factor. But there are a bunch of things fixed income investors can do to bump up their yields a little bit and, at the same time, not go too crazy in terms of taking on more risk. The first suggestion I’d make is ditching US Treasuries. As safe as they are, I think they have been bubbling for a while and I can’t make compelling arguments to keep them. I’m not saying one should sell treasuries because I perceive any risk in the US defaulting on their bonds (I don’t think they will at all) but the upside for treasury investors is, well, non-existent. Even going out 10-20 years doesn’t get you any sort of respectable return. So from a valuation perspective, goodbye treasuries from my fixed income portfolios.
Next move, look into some bonds outside the United States. I understand there are plenty of old-fashioned bond investors who prefer sticking to a lattered portfolio of government and corporate bonds, all issued from within the US and Puerto Rico. That may be because you prefer all bonds which you can understand. It also may be to avoid the risks inherent in foreign bonds including currency risk (for bonds not held in dollars) and political risk. For example, buying European bonds right now, especially in a country like Greece presents an investor with serious risk—you’re not getting a 10% yield for nothing! What I’m talking about is looking into a stable emerging market such as Brazil. You won’t get a killer yield from a country like Brazil but you can get 100-200 basis points (1-2%) over a US government bond with reasonable certainty that you’ll get paid back.
Next, investors should realize that higher interest rates are more than likely coming soon, as in during 2011. Locking into longer term bonds right now to fetch an extra percent is probably not a wise move. That doesn’t mean you need to hold all ultra short-term bonds. There are some bonds, especially within the corporate sectors which are less sensitive to changes in interest rates. You can also slide down the credit scale a little bit to catch that extra yield without going out too many years. That way, when rates move up, you’ll have cash to buy new bonds. Despite how obvious this advice may be, there will be plenty of people who mismanage there bond portfolios over the next few years and don’t maximize their potential total return.
I’ll throw this out there as a final idea for my fixed income investors. If you’re used to 100% bonds, consider moving 10% of your money into the lowest risk spectrum of equities—think: utilities, blue-chips stocks, etc. The US economy is getting stronger and it’s more than likely stock prices will increase over the next few years. If you want some income and a hedge for higher interest rates, consider adding some conservative equities with high dividend yields to your portfolio. You could also look into stocks which tend to do well when the economy retreats. You may find that you’re adding return to your portfolio without taking on too much more risk. You can revert back to all fixed income if you desire when interest rates move up over the coming years.
As always, feel free to e-mail me with any questions or comments.
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Bonds are subject to a variety of risks, including but not limited to interest rate risk. Government bonds are guaranteed by the US government and, if held to maturity, offer a fixed rate of return and fixed principal.
Securities and certain investment advisory services offered through: First Allied Securities, Inc., a registered Broker/Dealer. Member: FINRA/SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.