During any noteworthy selloff in stocks, you will find no shortage of investment advisors reminding you to take a long-term view and “buy the dip.” When in the midst of a bond market selloff, however, you are more likely to find no shortage of investment advisors telling you to avoid bonds. We live in a stock-market-centric investing world, a world in which there are incredible sums of money to be made if advisors can convince investors to keep buying stocks and if the stock market continues higher forever. It never ceases to amaze me all the reasons investment professionals come up with for why retail investors should stay away from bonds. As a bond investor, you must realize there will probably always be a surplus of investment professionals willing to express a gloomy outlook for the future direction of bond prices regardless of whether the gloomy view is warranted.
Over the past few months, yields across the fixed income markets have moved higher. As that occurred, bond prices headed lower. Some people view declining bond prices as a reason to run away scared. I view lower bond prices as an opportunity. When you invest in a security that will mature at a pre-determined price (such as bonds), lower prices is a gift worth accepting, embracing, and being thankful for.
Just as you would average into equity positions over extended periods of time, you can do the same in bonds. Averaging in at lower prices allows you to increase the average yield of your bond portfolio. And that’s a good thing for income-focused investors. But in case the current bond market investing landscape has you confused and perturbed, Bill Gross has some helpful reminders for how to protect yourself when entering the choppy waters of today’s fixed income markets.
In his August 2013 Investment Outlook, “Bond Wars,” Bill Gross shares with investors five “weapons” he collectively categorizes as “carry.” Carry, as Gross explained, is “another word for yield.” But, as he continued, it “often comes in forms less obvious than a fixed semi-annual interest payment.” In what other forms does carry come?
1. Maturity extension – If you are searching for more yield, you can find it in longer-dated bonds. Of course, by moving into bonds maturing further in the future, there is more short- and intermediate-term price risk. But for long-term investors holding bonds to maturity and properly managing their liquidity, price risk will be irrelevant. Additionally, if you attempt to capture more yield in the form of maturity extension, there is the risk you will lock in a yield for a very long time that eventually is lower than your personal inflation rate.
2. Credit spreads – Historically, spreads tend to widen when benchmark yields fall and contract when benchmark yields rise. This is because benchmark Treasury yields typically fall during times of economic stress and rise during times of strong economic progress. In recent months, there has been an anomaly in which corporate spreads have widened at the same time that benchmark yields have risen. This has to do with fears of the Fed’s tapering QE and an expectation that tapering would lead to a weakening economy. If we return to historical norms, then contracting spreads can provide some shelter from rising benchmark rates, thereby acting as a type of carry.
3. Yield curve – The yield curve can act as a form of carry when it is upward sloping. A steep yield curve not only allows longer-term investors to capture more yield through maturity extension, but it also allows shorter-term investors to capture additional premiums in the form of riding the yield curve.
4. Volatility – Some bonds are more sensitive than others to changes in interest rates. These bonds carry volatility premiums, which are meant to compensate investors for taking on the risk of owning more price-sensitive bonds.
5. Currency – Bonds that are non-dollar denominated have the potential to add carry to a portfolio.
Just for good measure, I would like to add another type of carry to the list: Yankee bonds. Yankee bonds are U.S. dollar denominated bonds issued in the United States by non-U.S. governments and corporations. In addition to helping you geographically diversify a bond portfolio, Yankee bonds typically carry slightly higher yields than U.S. companies with comparable credit risk. Whether this is due to a general unfamiliarity with the foreign entities issuing debt, unfamiliarity and risks associated with a bondholder’s legal rights when dealing with foreign entities, something else, or all of the above, one thing remains clear: It is not unusual for Yankee bonds to offer carry.
In his aforementioned Investment Outlook, Bill Gross referred to the various types of carry as weapons. If you are a bond trader (short- to intermediate-term focus) rather than a long-term bond investor (held-to-maturity focus), I understand the temptation to refer to forms of carry as weapons. As a long-term bond investor, I prefer to think of various types of carry as tools that help me sculpt the perfect bond portfolio for my investment objectives. But however you want to think about carry, and whether you choose to focus on just one type or on all types of carry, being aware of the different ways in which you can enhance your bond returns will likely serve you well over your investing lifetime. I am glad Bill Gross brought attention to this in his latest “Bond Wars” (his original “Bond Wars” was published in May 1986. You can find it here).
More from The Financial Lexicon:
Learn how to generate more income from your portfolio.
Get our free guide to income investing here.