Portfolio Management Preferences to Reduce Risk
LOOK BEYOND TREASURIES
U.S. investors have easy and relatively inexpensive access to a broader selection of bonds than they had in 1994.
- Non-U.S. bonds provide U.S. investors access to different economic cycles, interest rates and currency values which can help reduce overall portfolio risk.
- Floating rate bank loans are another portion of the bond market that actually do better in rising interest rate environments. These loans are very short term, resetting every 30-90 days.
High-yield corporate bonds (those below investment grade ratings) have historically performed much better than other bonds during periods of increasing interest rates.
Consider this research reported by Investment News writer Jeff Benjamin:
According to an analysis of the biggest interest rate moves over the 20-year period through June 2006, high-yield bonds are remarkably resilient against interest rate volatility. Between September 1987 and June 2006, there were six separate 12-month periods that saw the yield on the 10-year Treasury climb by between 117 and 222 basis points. The average total return of high-yield bonds for those same 12-month periods was 5.5%, with just one negative-return period.
THE TOUGHEST DECISION
If your investment mix currently includes a significant overweight to stocks, should you leave it that way or diversify to include bonds at a point when bond returns are not expected to be nearly as good as they have been over the past few decades?
While the potential to see the value of your bond holdings drop is discouraging, watching them decline perhaps a few percent should be much more palatable than watching a stock investment decline significantly more.
If global economic conditions receive any more shocks, it’s conceivable that U.S. and international stocks could return to a bear market, declining 20% or more. In this case, having some bond exposure creates downside protection in a broadly diversified investment mix. It may be a hollow victory for bonds if all they do is lose less, but their ability to steady a portfolio amid periods of stock volatility can be valuable.
Let’s not forget that since March 9, 2009, the U.S. stock market has been on an exceptional run. The S&P 500 Index gained 85.5% as of December 22. Small companies, as measured by the Russell 2000 Index gained 130.3%. A correction would not be surprising.
WHAT ABOUT MUNICIPAL BONDS?
The biggest fear in the municipal bond market isn’t so much interest rates as it is pure default by the municipality. Clearly, government entities at all levels are faced with significant deficits. Historically, municipal bond default rates have been very low, essentially not a concern expect in a few high profile cases (Orange County, CA, the WPPSS nuclear project here in Washington). Holding a diversified mix of many different types of municipal bonds can minimize default risk.
Many people assume that if cities or other municipal entities fail, the Federal Reserve will bail them out, saving value for bond holders. This could be the case but may serve to further bog down the economy.
Even if we see 50-100 imminent municipal defaults as Meredith Whitney forecast on 60 Minutes December 19, that is a small percentage of the overall municipal bond market. If your municipal bond exposure is in an actively managed mutual fund with an experienced analyst monitoring credit ratings, the default impact may not be all that significant.
IS CASH A BETTER BET?
Shifting the fixed income portion of your investment mix to cash comes with an opportunity cost. What if interest rates don’t move quickly and bonds continue to produce attractive total returns? What if U.S. interest rates increase slowly and bond returns decline moderately?
If your current bond holdings are in a portion of your portfolio that can’t take even a minor loss in the next two years, we think that this investment should be in cash. If you can afford to take a limited amount of risk, we think that concerns about bond declines may be overstated from a longer-term perspective. More importantly, cash holdings do not rally.
EXPECTATIONS ARE BUILT INTO MARKET PRICES
All investment markets are driven by future expectations. These expectations are already priced into stocks and bonds. Bond investors don’t generally expect the same tailwind that has filled their sails for most of the past generation. A less friendly headwind may already be evident in the price of bond funds.
WHY WE PREFER BOND MUTUAL FUNDS OVER INDIVIDUAL ISSUES
We feel more comfortable letting professional bond managers navigate the opportunity and pitfalls the market presents. Bond fund managers spend their days building portfolios that are liquid, sensitive to the outlook for interest rates, and focused on managing the risks and returns for their investors. Unless you are certain as an individual investor that you will hold individual bonds until they mature, receiving a payout of the bond’s face value, and that you have enough individual bonds to diversify away as many of the risks as possible, it is unlikely you will be able to outperform these professional managers on an ongoing basis.
Considering the open issues and historical precedent, investors definitely need to ratchet down expectations for U.S. bond returns. But we don’t think you need to run away from U.S. bonds altogether. And your portfolio may be optimized by expanding to include international bonds.
~ Gary Brooks, CFP®, Allyn Hughes, CFP®, and Nancy Jones, CFP®, — Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA