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North Bay Business Journal

Monday, October 29, 2012, 6:30 am

The role of bonds in an investment portfolio

By Bill Schrader, CFP

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    Part of my role as a financial consultant is to help clients coordinate their investments relative to their goals, risk tolerance, and the time frame associated with their objectives. Many investors recognize the potential benefits of diversifying within and among the various asset classes based on their time horizon and risk tolerance; however I have found many are beginning to question their allocation to bonds. In this challenging time for investors, let’s take a look at a few considerations when it comes to fixed income investments.

    With the current low interest rates and concern around bond prices declining if rates eventually rise, it is tempting to wait and keep money in cash investments.  But it’s important to consider that by staying out of the bond market altogether, investors can run the risk of missing out on potential income that can compound over time. Also, trying to time the bond markets can be very difficult and risky – so trying to time the moment that interest rates will rise is not an approach we’d generally suggest.

    To put some numbers to this, let’s hypothetically assume an investment of $50,000 in a three-year AA municipal bond yielding 1.5 percent. This municipal bond would be expected to earn $2,300 over a three-year period. If you waited in cash earning no interest for one year before investing, the bond’s yield would need to rise to around 2.2 percent in order to generate the same amount of return. If you held cash for two years, it would need to rise to a 4 percent yield to make up for lost income. 

    Many people believe bonds can play an important role in an investor’s portfolio, but what exactly are they intended to do? Bonds can help preserve capital and provide diversification in many different market environments.

    Interest rates may be here to stay for the time being because of the Federal Reserve’s stated interest rate policy and the sluggish growth of the U.S. economy, but that doesn’t mean now is the time to be complacent about the risk of rising interest rates down the road. The reality is that there is more room for rates to rise than to fall, and while current rates are below inflation, real returns could be negative.

    With a bond ladder strategy, investors can spread out bond maturities over time in an effort to create a predictable income stream. This strategy can provide the flexibility to reinvest short-term bonds at higher rates if the interest rate rises, while still having some bonds locked in for the longer term if interest rates drop – which could be particularly useful for those approaching retirement and looking for more consistent income.

    Ladders may not outperform portfolios with more narrowly targeted maturities and bond prices will still decline if interest rates rise, but we see the benefits as outweighing the risks for many investors, especially in the current low-interest rate environment.

    While some people are sitting on the sidelines in cash, the current interest rate level is leading others to put money into certain riskier investments in search of higher potential yields. But we think it’s important to keep diversification in mind. One way to potentially diversify an investment portfolio and try to increase returns and lower duration risk is with high-yield bonds, international bonds, and multi-sector bond funds. Here are a few thoughts on each each:

    • High-yield bonds: The average annual return in the high-yield bond market over the past two years has been around 10 percent compared to an average of 6.5 percent for the Barclays U.S. Aggregate Bond index which is a broad bond market index. Homework must done before investing since high-yield bonds are typically far more likely to default than higher rated bonds and tend to be more correlated with the stock market, which has had its fair share of ups and downs, compared to the Treasury market.
    • International bonds: Since 2008, international bonds haven’t provided the level of diversification seen in past economic cycles. In the long term, though, we think there’s a good chance that historical diversification could return and allocation to the foreign bond markets might be worth another look. Investors should also keep an eye on emerging-market bonds, as sovereign emerging market issuers typically carry less debt relative to the size of their economies than in developed-market countries. However, these markets tend to be more volatile and less liquid than bond markets among The Group of Ten, so we would suggest limiting exposure in a fixed income portfolio.
    • Multi-sector bond funds: Multi-sector bond funds generally have the flexibility to look for opportunities across a range of global bond investments, which we believe is increasingly important in today’s rate environment. However, more flexibility and higher potential return comes with added risk. These types of funds have tended to take on more credit risk rather than duration risk in their search for yield, including currency and high-yield credit exposure. Given this, these funds can be more volatile than less aggressively invested bond funds, especially in periods of market stress.

    A common view about bonds can be that they are only right for retirees or they are something you give as a high school graduation gift, but bonds can play a critical role in a properly diversified investment portfolio, and they can also be a way to help add some relatively predictable income over time. This was a very high-level overview of some timely considerations around investing in bonds, but it’s important for all investors to take a look at their own financial priorities and goals and develop a plan that is tailored to their specific situation.

    Bill Schrader, CFP®, is a vice president-financial consultant with Charles Schwab’s Corte Madera branch. Mr. Schrader has over 25 years of financial services experience and assists clients with help and guidance around retirement, investing and planning for financial goals and priorities. He can be reached at bill.schrader@schwab.com or 415-945-6404. (1012-6796). The information here is for general information purposes only and should not be considered an individualized recommendation or personalized investment advice.

     

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