With certificates of deposit, treasury obligations, and money market funds paying all time low rates of interest, safely investing for income seems relatively impossible. There are a number of reasons for this predicament, not the least of which includes the situation in Europe driving a significant demand for “flight to quality” U.S. based obligations, and the Federal Reserve holding rates artificially low for an extended period of time.
Regardless of the reasons the truth is that the demand for bonds has risen dramatically over the last year. As demand goes up, supply goes down, and prices rise. Basic economics really. When the prices of bonds rise, the yields or amount of interest you earn on your investment in those bonds declines. In order to earn higher rates of interest, you either have to be willing to take a greater risk by investing in lower quality bonds, or buy bonds with much longer maturities. As you might imagine, there are a couple of potential problems here.
In order to entice investors to buy lower quality bonds (called high yield bonds or junk bonds), the debtors must pay more interest than can be obtained from much safer investments such as treasury obligations or AAA rated corporate bonds. But there is a catch. With junk bonds, there is a greater chance that you might not get your principal back if the debtor goes under.
Another way to earn a higher rate of interest is to extend the maturity of bonds you buy. The longer the term of the bond (the longer the period of time before the bond matures and you get your principal back) the more interest the debtor must pay. This is because the future is uncertain and there needs to be a higher reward interest wise, by tying up your money for a longer period of time. But tying up your money for a long period of time is also risky. For example, a ten year treasury bond pays about 1.9 percent today. You will earn 1.9 percent a year, but you won’t get your money back for 10 years. If you want to sell that bond before it matures in 10 years, you could lose a substantial amount of principal if interest rates are higher at the time you want to sell. That is because if current interest rates are much higher than the 1.9 percent you are locked in to on your bond, a buyer would require you to significantly discount your bond to bring his total return up to the current market.
Given that the probability of inflation and higher interest rates is almost certain in the coming years, locking in to longer term bonds now poses a good deal of risk. So what to do?
Short, Intermediate or Long?
So we know that short term bonds pay less interest than intermediate term bonds, and intermediate term bonds pay less interest than long term bonds. When interest rates rise however, the shorter term bonds are far less susceptible to loss of principal than intermediate and long term bonds. In fact, the longer the term on f the bond, the more principal that will be lost as interest rates rise. In the current environment, there is a much higher probability of interest rates rising rather than falling, so locking in to long term bonds now would not be a good idea. At the present time, I prefer a mix of short to intermediate term bonds, with an average maturity of 5 to7 years, as a “sweet spot”. These bonds are not as susceptible to interest rate increases as the long term bonds, but by adding intermediate term bonds, the overall yields will be higher than short term bonds alone.
Individual Bonds, Bond Mutual Funds or ETFs
When you purchase an individual bond (as in a bond ladder), the bond pays interest twice a year and at maturity, your principal is returned to you. Individual bonds can carry more risk if the payer of the bond defaults before the bond matures. Another option is to invest in a mutual bond fund. A mutual bond fund is essentially a large basket of bonds, often holding hundreds of individual bonds at any given time. When you invest in such a fund you own a small piece of many bonds. This reduces the risk you might otherwise incur by holding individual bonds, as any default of an individual bond in a fund would represent only a minor part of the whole basket. The real advantage of a bond mutual fund is that they are typically actively managed by advisors, who buy, sell and rebalance based on market conditions. In a volatile environment, such as we have currently, actively managed funds can have some real benefits. Finally, we have the ETF bond fund. Electronically Traded Funds then to be structured more to represent a particular index, rather than to be actively managed (though those do exist as well). ETFs are useful when trying to build a bond portfolio to hold specific bond assets classes such as government bonds, corporate bonds, emerging market bonds, etc. ETFs are inexpensive to buy and sell, have very low internal costs, and trade immediately like a stock (whereas mutual funds trades only once at the market close each day).
Create a Bond Ladder
The bond ladder has been a staple of bond investing for years. It works like this. Put 20% of your investment money each in to individual bonds that will mature in one year, two years, three years, four years and five years. At the end of the first year, when the first 20% matures, use that money to buy bonds maturing in 5 years. As each year maturities come due, buy bonds five years out. The theory is that if interest rates are rising, each successive investment will generate a greater rate of return. Conversely, if interest rates are declining, some of your previous purchases will be locked in paying higher rates than currently available.
In the current market environment, even bonds five years out are paying nearly nothing in interest, so I am not fond of this strategy at the present time. At some point in the future however, this strategy may again be very effective. Which brings up a good point. Investing strategies should not be etched in stone. What works well at certain times may not work well at other times. The skill lies in being adaptive to the economic environment around you at the time, going with the trends rather than against.
Putting it All Together
Remember that investment strategy is a fluid proposition and what is best today may not be tomorrow. With that caveat, here is the bond strategy I currently favor for our clients.
In the same way that modern portfolio theory teaches us to build a portfolio of stocks, bonds and alternative assets, all of which are inversely correlated to each other, in this environment, I prefer a bond portfolio that is inversely correlated within itself, made up of a combination of mutual bond funds and ETFs, with a short to intermediate term average maturity. The bond categories include the following:
Investment Grade Corporate Bonds
High Yield Corporate Bonds
Agency Bonds (GNMA, MBS CMO)
Emerging Market Bonds (denominated in local currencies)
Emerging Market Bonds (Denominated in US dollars)
Global Developed Markets Bonds (sovereign and corporate)
Emerging Markets Dividend Paying
US Dividend Paying
Now bear in mind that while I describe this as a bond portfolio, it is really more appropriate to call this a fixed income portfolio. The dividend paying funds are based on stock holdings of high dividend payers, and are not bond funds at all. The dividend paying funds, and the high income bonds, tend to move up when the stock market moves up, and down when the stock market moves down. In other words, they tend to be more correlated with stocks than bonds. On the other hand, the government and agency bonds and some of the global and corporate bonds tend to rise when the stock market falls, as money flows from risk to safety. Emerging markets obligations in local currency can be a hedge against changes in the US dollar. Overall then, in a volatile market environment, this type of approach is intended to keep the overall principal value of the bond portfolio stable, while earning a higher yield than would otherwise be available by merely investing in short duration or government bonds alone.
Anthony Caruso, CPA has practiced as a certified public accountant and investment advisor for over 30 years. Caruso and Company, P.A. is a Registered Investment Advisor offering fee based money management, tax and financial planning. Information contained above is not intended to be a recommendation to buy or sell any specific investments, and investors should consult with their advisors for appropriate advice relating to their individual circumstances.