Which Bond is Your Favorite?
By Nick Hughes, CFP®
Early on in my career, I took an interest in bond investments and particularly the role that they play in a sound portfolio. While many advisors were more interested in finding the next hot stock, I would scour bond inventories and keep an eye on short-term and long-term interest rates. This provided me a tremendous education on how to utilize bonds to provide income, stability as well as some mistakes to avoid. With the Federal Reserve’s latest interest rate decision impacting the markets, I thought it was a good time to share some of the things I have learned.
1. Don’t Get Caught “Reaching for Yield”
While bonds have long been used by investors to generate predictable income in their portfolio, this has become increasingly more challenging to accomplish in a lower interest rate world. Because the interest payments and underlying promise to return principal are backed by the government or company issuing the bonds, those that are more credit worthy tend to also pay the least amount of interest. This has caused some to “reach for yield” by seeking out the higher interest payments from more speculative bonds or “junk bonds” that tend to have much higher rates of default. Defaults tend to be lower during prosperous economic times and spike when the economy is getting weaker. Owning bonds in default can mean not earning the income you had hoped for or even worse potentially losing hard earned principal if the issuer isn’t able to pay bondholders back at maturity. Unlike films about our favorite secret agent, sometimes boring beats exciting.
2. Who Should Own Bonds? Just About Everyone
I believe the financial press and media are mostly to blame for investors’ lack of knowledge about bonds and under-allocation to them. This is due to the financial media constantly tempting investors with the allure of the next hot stock tip and focus on arbitrary stock indices like the S&P 500 and the Dow Jones which aren’t a good comparison for how most investors’ portfolios should be invested. Because stocks and bonds don’t always move in tandem, allocating the right percentage of your portfolio to bonds can smooth out the ride over time (see chart below). Maintaining stability, at least for the portion of dollars you plan to spend in the next several years is important as you don’t want to have to sell off a chunk of your portfolio while market prices are depressed. Being forced to do so can increase your chances of running out of money in retirement. Work with your financial professional to determine the appropriate amount to put into bonds. This conversation should be based on your needs, expected investing timeframe, and comfort level with risk.
3. Manage Interest Rate Risk
Bonds, even the most high quality bonds issued by the US Treasury are not risk-free. One of the risks you face with bond investments is that interest rates may change in the future affecting the value of your bond investments. For instance, if you were to purchase $10,000 in 5 year bonds with a 3% coupon rate payable annually you can expect to receive $300 dollars per year in interest payments for 5 years and $10,000 back when the bonds mature. If interest rates on similar bonds (same credit rating and time until they mature) increase and investors can now get a 4% coupon on similar bonds you should expect the value of your bonds to decline. In a rational market you should expect another investor to pay no more than $9,554.82 for your bonds with the 3% coupon equally a decline in the value of your investment of 4.5%.
Because predicting changes in interest rates is just as impossible as predicting the ups and downs in the stock market, it is important to manage this risk. One way to do that is by holding individual bonds until their maturity date. In doing so, your return is locked in for the life of the bond. This is particularly effective when using a bond ladder. For example, if you had $100,000 to invest for 10 years you could purchase 10 bonds for $10,000 each, one maturing each year. By staggering your maturities this way, you will have an influx of money coming in regularly that will allow you to reinvest at current market rates (which may have increased) or prevent you from having to sell some of your bonds at inopportune times (after interest rates have increased).
4. Own a Globally Diversified Bond Portfolio
Because interest rates are hard to predict and can affect bond prices it is important to own a portion of bonds from outside of US borders. Bonds in countries or regions where interest rates are falling may outperform other parts of the world where interest rates may be increasing. Just as you are more likely to come across larger and more diverse fish when Deep Sea Fishing than you would fishing in the pond in your backyard, you can typically find more opportunities in the bond market if you expand your search globally.
Because markets and your situation can change quickly, it is important to re-evaluate your portfolio in context with your long-term financial plan at a minimum of annually. Good economic conditions and rising markets can mask underlying deficiencies and it never hurts to have a financial professional provide you with a second opinion. What we don’t know can hurt us and our families and additional peace of mind and reassurance will be well worth your investment in time.
(sources: Moody’s, JPMorgan Asset Management, E-Trade, Dimensional Fund Advisors)
Nick Hughes, CFP® is a Wealth Advisor with Visionary Horizons, a Registered Investment Advisory Firm in Chattanooga, TN. Nick has been helping retirees and widows simplify their financial lives and develop more clarity about their future since 2007. He has contributed to articles for Market Watch and FinancialPlanning.com and is a regular contributor to the Visionary Horizons blog.
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