Bonds still offer stability to a diversified portfolio. By Jeff Brown
Bond yields have soared in recent months, with the yield on the 10-year U.S. Treasury going from 1.4 percent in June to about 2.3 percent now.
What's not to like about that? After all, fixed-income investors have been griping about low yields for years. Well, there is a dark side. Higher rates are tough on borrowers who will have to pay more for homes and cars if things keep going this way.
What should investors do today? Many experts say that if bonds deserved a role in your portfolio six months ago, they still do.
"In general, we believe the benefits of higher yields outweigh the need to avoid falling bond prices," says Russell Robertson, a planner with Alidade Wealth Partners in Atlanta.
"Bonds still serve a valuable diversification role within portfolios, so a higher yield on them is just an added benefit. It's a little counter-intuitive, but an ideal asset allocation, from a risk/return standpoint, should have one asset class that is falling in price."
Consider a simplified example. Suppose your old bond yields 2 percent and cost $1,000 new. Now suppose a newly issued bond pays 4 percent and also goes for $1,000. An obvious option is to sell the old bond that earns $20 a year and buy the new one earning $40. But why would anyone pay you $1,000 for an old bond that earns half as much?
They wouldn't. In fact, the price of the old bond would fall to $500, the point at which $20 in annual earnings equals the 4 percent available on the new bond.
In real life it's much more complicated and the price drop might not be so bad, mainly because the interest earnings on the old bond could be reinvested for a higher yield today and the investor would know she'd eventually get back her $1,000 when the bond matures.
But there's no escaping the fact that rising rates undermine the value of older, stingier bonds and bond funds. The price drop is more severe for bonds with longer maturities, because owners will be stuck with below-market earnings for so much longer. A bond maturing next month will lose virtually nothing if rates rise, because the investor knows he'll get his principal back soon, while one not maturing for 30 years will be hammered.
That's why some advisors recommend steering clear of bonds with long maturities.
"It has never made sense to invest in bonds with maturities much longer than five years. You pick up substantially more volatility with very little reward," says Paul Ruedi, CEO of Ruedi Wealth Management in Champaign, Illinois.
How will things unfold?
"We expect interest rates to continue rising over the next year if not longer or until the Federal Reserve stops raising rates," says Jonathan J. Monjazi, founder and CEO of Monjazi Capital in San Diego. "We think bonds are still key to a client's portfolio as they are generally much less volatile than stocks, so we are moving client assets into short-term bond funds with low duration to reduce client exposure to higher interest rates."
The first step. Think about your risk tolerance, or how well you could manage if things don't go your way. A retiree who owns nothing but bonds and is completely dependent on interest earnings has less tolerance for risk than someone who's also getting a pension, Social Security and dividend income. The less risk tolerance you have the more likely you should change something, like converting some holdings to stocks, cutting expenses or paying down debts.
Investors with bond funds should remember that the fund constantly sells older bonds and buys newer ones to maintain the characteristics like average maturity promised investors. Over time, the fund catches up and owns more and more bonds with higher yields
Bond investors can also look for a figure called "duration," expressed in years. A five-year duration means the bond would lose 5 percent of its value for every 1-percentage point rise in interest rates, or gain 5 percent with every 1 percent fall in rates. If you plan to hold the bond or fund longer than the duration, rising earnings will probably offset what you lose initially as rates go up.
"If rates are going down, you want a higher duration because the price of your bond will go up," Monjazi says. "If rates are going up, you want a low duration because you want your bond price to be less affected."
Also remember that bond's aren't just for interest earnings. They also help calm a portfolio that otherwise would jump around in value because of stock price changes. You still get the benefit of diversification even if your bond values dip.
Individual bonds, bond funds and exchange-traded funds. Individual bonds allow the owner to wait out a price drop, since holding to maturity guarantees a return of principal at face value if the issuer is solvent. Most funds and ETFs don't have a fixed maturity but constantly change their holdings to maintain an average maturity. But funds make it easy to diversify bond holdings, so no single bond can do much damage.
"We prefer low-duration bond funds over individual bonds because of the level of diversification bond funds provide," Monjazi says. "In our view, individual clients do not get the necessary diversification with individual bonds. We think bond ETFs are a great tool for bond exposure but we believe it really depends on the person managing the ETF."
A number of ETFs offer fixed maturities, allowing the investor to wait out downturns as one would with individual bonds, while still providing diversification among issuers.
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