One of the most critical aspects of bond strategy is the amount of maturity and associated duration “risk” one is willing to take when crafting a portfolio. I put the word risk in quotation marks because risk is always in the eye of the beholder. Over the past 30+ years, with interest rates generally moving in a downwards slope, the real risk in bonds was to have held issues with shorter duration. Though no money was “lost,” there was an opportunity cost relative to holding securities with longer duration.To see a list of high yielding CDs go here.
10 Year Treasury Yield – 1984-2014
Fast forwarding to today, bond investors are being told that there is tremendous risk in
holding longer duration bonds. I have cautioned similarly in previous articles. And that might be true. Of course predicting the future path of interest rates might be akin to forecasting next week’s weather. We can see storms brewing in the distance, but generally can’t tell how much rain or snow will fall until the storm is much closer, and even then we are rarely perfect.
Such is predicting the economy. While popular consensus seems to be that the economy has bottomed since the financial crisis of five years past, and may be in fact improving, do we really know where it will stand five years from now? Many seem to think that the 10-Year Treasury will begin a reversal of the thirty year trend we’ve seen. Yet that prediction has been a popular one for years now, and hasn’t been correct.
So while many pundits may feel the “odds” of an interest rate rising scenario are likely, odds don’t generally predicate interest rates, reality does. Back in 1984 with the 10-Year trading with a yield in the low teens, my sense is that the oddsmakers would have called it crazy to think that in 30 years the yield would be less than two percent. The bottom line is that rates will rise because economic fundamentals dictate that they should, not
because “it’s time for them to rise” or because they’ve been low for too long. As a parting shot on this issue I will note that our ten-year sits at about 2.7% right now – Japanese 10-year paper sits at about 60 basis points, a full two percent lower.
What Is A Bond Investor To Do?
We do know that domestic interest rates cannot possibly drop 1000 basis points like they did over the past 30 years. So we know that the rewards of owning bonds from both a total return and a current nominal yield perspective are not particularly fruitful. Of course not all bond investors are looking for a robust total return opportunity. Therefore strategic maturity/duration decisions will vary from one investor to the next.
So two investors looking at the 10-year Treasury could view the opportunity totally different. For someone concerned about capital preservation and needing something in excess of current money market yields, that 2.7% could seem like a good deal. Another investor might view 2.7% as comparatively low and possessing too much duration risk, with assumptions for a steepening yield slope.
In essence, one must define their goals, personality, and forward interest rate perceptions before making duration decisions. The most “rate agnostic” of bond strategies is generally considered to be the bond ladder, which takes the prediction factor away from the mix. Investors buy long bonds on a regular basis to replace maturing bonds, with a stepped maturation schedule. This would be akin to buying index funds as a proxy for equities. You don’t try to beat the market, but accept what it is doing at any one point in time.
For the more strategic total return investor who’s interested in doing better than what the market is currently throwing their way, I like high-yield bonds with short duration. Though my sense continues to be that rates will remain low and credit quality steady, I’m not sure that the possibility of being “long and wrong” is worth it. So for the more aggressive investor, I would recommend something like Prudential Global Short Duration High Yield (GHY), a levered closed-end fund trading at a discount to NAV with a 8.5% payout and 2.5 year duration. For the less daring, the old high-yield stand-bys of HYG and JNK are certainly worth considering.
While logic might dictate that interest rates have no where to move but up, I wouldn’t base investment decisions on statistical assumptions. If you think the economy is improving on a wholesale level, then that would be reason to keep duration to a minimum. On the other hand if you think recovery assumptions are far overstated and that rates will remain low, skew a portfolio toward the long end, but understand the “risks” of being wrong.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.
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