Bonds #2: Replacing bonds with bonds
Last week we peeked at what the bond market might have in store for us going forward. We learned that if interest rates were to rise, the value of existing bonds would go down. For the past few years bond market observers have been predicting a rise in interest rates. Those predictions have proven wrong mostly because the Federal Reserve has continually done everything it could to keep rates low.
The Federal Reserve saying they would reduce their bond buying stimulus program if the economy recovers was enough to send the global markets into a tizzy. This is a future event that we alreadyknew was going to happen, but only if the economy got better. And yet, the mere mention of it caused stocks and bonds around the world to drop. That’s why this week we begin looking at some of the alternatives to bonds.
Our first alternative to bonds is, well, bonds.
One very popular choice is to buy higher yielding bonds. People figure that if they get a bond paying high enough, the drop in bond values won’t hurt as much. In a way that is true. But why are the higher yielding bonds yielding higher?
Companies don’t pay high interest rates if they don’t have to. After all, there is a reason that high yield bonds are called junk bonds: they are issued by riskier companies. Correspondingly they have higher default rates. Since people are worried whether or not the company will succeed so it can pay its debt, the same factors that cause its stock price to fall will also cause its bond price to fall, so you lose some of the diversification effects that bonds bring to a stock-bond mix. This means that while you may have increased your expected return to something more than negative, you are doing so at markedly increased risk both to your bond holding and to your portfolio as a whole.
Another way to combat the eventual decline in bond values is to shorten the duration of your bond holdings. Remember, duration is a measure of a bond’s movement due to interest rates: The lower the duration, the less risk. Duration follows maturity very closely, so a short- or ultra-short bond or bond fund greatly reduces the volatility of a bond portfolio.
The trouble here is that unless you buy the riskier shorter-term bonds, you’ll earn a pitiful amount of interest. By gaining safety, you hamper your return.
Foreign bonds have attracted a lot of investors recently, particularly those from the world’s emerging economies. They have provided more income than domestic bonds. The problem is…well, they are foreign. They include the normal risks of bonds; their interest rates can go up just like ours, and their bonds can default due to economic circumstances. When you add some very real political and currency risks, you can see that while the risks may manifest differently they are alive overseas as much as they are here. If a transient event scares recent foreign bond investors, a stampede might ensue.
Still, there is a way to diversify away from your plain-vanilla bond portfolio. We’ll look at that next week.
This article was published under the title "Let Bonds be Bonds, But Higher in Yield" in the Wichita Falls Times Record News on July 21, 2013.