Amid continuing upheaval in world stock markets, investors are rediscovering an old love: bonds.
So far they’ve been rewarded. While stocks have encountered heavy turbulence since the fall, tumbling interest rates have sent bond prices, which move in the opposite direction, soaring.
Inspired by the gains, investors added approximately $47 billion to bond mutual funds last year, topping the previous three years combined. But a strong argument can be made that investors should shy away from bond funds and build their own portfolios of individual bonds.
For one thing, bonds, unlike stocks, have a limited upside. Interest rates can’t go below zero. As such, sales charges and management fees on bond funds usually eat up a larger percentage of an investor’s gains than is the case with stock funds.
Meanwhile, bond funds, as many investors learned in 1994’s bond-market slump, don’t always do a good job of protecting investors’ principal. That’s because a bond fund’s share price fluctuates as the value of the bonds in the fund’s portfolio rises and falls with market conditions; there is no point at which you are guaranteed to get back what you put in if you sell.
In contrast, investors who buy an individual bond and hold it to maturity always get back their investment, assuming the issuer doesn’t go belly up.
How do you build your own bond portfolio? The following questions and answers should help guide you.
– What are you looking for in a bond investment? Generally speaking, there are two types of bond buyers. On the one hand, many people depend on a stream of income payments or simply want to protect their principal. Others are attracted to bonds as a way to help reduce the risk in a portfolio that may be heavy with stocks, or they simply see bonds as offering the better opportunity to score gains.
If you’re in the first group, bonds look attractive at today’s yields in the 5 to 6 percent range. Inflation could fall below 1.5 percent this year, and some economists spin a scenario in which deflation–an extended fall in prices–materializes in the year ahead.
Viewed on a total-return basis, bonds are a tougher call. A sudden unexpected rise in yields would mean a drop in bonds’ market value. Especially in the case of a longer-term bond, the decrease in value could more than offset the income an investor receives from interest payments, plunging the investor’s total return into negative territory.
At least for the moment, though, few analysts see interest rates rising soon.
– How should you build your portfolio? Perhaps the most important question for a bond investor is which maturities of bonds to buy–or, in bond parlance, how far to go out on the “yield curve.”
The traditional advice is to “ladder” your portfolio. This simply means buying bonds maturing in a series of years, such as two-, five- and then seven-year bonds, to guarantee a stream of interest payments that can be reinvested.
The laddered approach makes the most sense for those investors in it for the very long haul and aiming to guarantee a stream of reliable income payments.
But a more aggressive “barbell” strategy of buying just long- and short-term bonds may be the best choice in the current interest-rate environment, especially for investors less concerned about living off their investment and more interested in increasing it.
The logic is as follows: If economic weakness materializes and inflation remains low, short-term bonds will prosper and long bonds could do even better. If the long bond falls to 5 percent by the end of the year, the total return on 30-year Treasurys would be more than 16 percent.
“I’d recommend 50 percent long and 50 percent short,” says Richard Ganz, fixed-income chief at Goldis Financial Group.
The flat shape of the yield curve encourages a barbell strategy. A 5.26 percent yield on two-year notes isn’t much less than the 5.45 percent yield on 10-year notes, rendering medium-term securities unattractive. But the 5.74 percent yield on 30-year bonds is enough to encourage investors to place at least some money in longer-term securities.
– What’s your appetite for risk . . . and what’s your tax bracket? Once you’ve decided what type of maturity to buy, you’ve got to pick a bond. Those investors with a low tolerance for risk should stick to government-backed Treasurys. Treasurys are also the easiest to buy. Through Treasury Direct (202-874-4000 or your nearest Federal Reserve Bank) individuals can participate in auctions of Treasury securities at no charge.
Municipal bonds should also play a part in most bond portfolios, especially those of investors in higher tax brackets, because many are currently trading at sizable discounts to comparable Treasurys.
“Don’t be blindsided by their (low) yield–munis are a good value relative to Treasurys, which is key,” argues Marilyn Cohen of Envision Capital in Los Angeles.
Inflation-linked bonds may also be a good value, especially if you think inflation can’t stay this low in coming years.
For investors with a greater risk tolerance, corporate bonds are the way to go, because they provide a higher yield. But fewer triple-A-rated bonds exist than ever before, rendering the challenge greater for individual investors, many of whom are uncomfortable judging credit quality on their own. Thus, a mutual fund is usually the best idea for corporate bonds, especially when it comes to riskier junk or emerging market bonds.
– What are the dangers? Besides default risk and rising interest rates, the most overlooked bond-buying danger is complacency. Many investors buy a bond, put it in a safe-deposit box, and don’t look at it again until it matures. But because interest rates and bond prices always change, the value of your bond portfolio will, too.
Another overlooked danger: call provisions. Many bonds are sold with provisions that allow the issuer to pay off investors early. When interest rates fall, issuers often call their bonds, forcing investors to scramble to put their money to work at a time of falling rates. So keep the call provisions in mind, or just stick with Treasurys, which can’t be called.
