Coping With The Limitations Of Investment Grade Bonds

While I probably sound like a broken record by pointing out the fact, today’s low interest rate environment continues to create havoc for income investors looking for a safe and reliable stream of income. And though we’ve heard predictions for many years now that rates will be going higher, a weak domestic economy continues to put the kibosh on any meaningful move on long rates. Meanwhile, with the Fed pushing onward with the taper of its stimulative bond buying, a light can be seen at the end of the tunnel for a tightening of short rates – although it may arguably be a very long tunnel.

  To see a list of high yielding CDs go here.  

For risk averse bond investors, the coupons available in most investment grade securities are hardly what one might call robust. In the chart below that I recently pulled from Fidelity’s web site, we can see that unless one wants to decrease credit quality and increase duration, there’s not too much to get excited about yield-wise. And for those few “exciting” yield pockets, where payouts get above 5%, it could be argued that far too much maturity risk is being taken with a forthcoming rate hike bonanza looming.

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So how does the fixed income investor deal with continuing yield starvation and forward bond market rate risk? For many, the answer may be simple – establish a bond ladder. Bond ladders take the guesswork away from forward interest rate movements. By establishing a portfolio with incremental maturities and making a commitment to buy long-term bonds with matured monies, one develops a market agnostic approach to fixed-income investment. Of course if you establish a ladder today, your yield would be lower than if you went all-in on long-term bonds, but your opportunity costs will be much lower assuming interest rates start to spike over the next couple of years.

For the less passive bond investor or someone trying to get the best deal in the bond market today, attempting to find the “sweet spot” of yield and maturity is another good way to cope. In essence one is looking for the best combination of reward for duration risk being taken. In my personal view, there is somewhat of a sweet spot in the 5-10 year duration range currently. Anything less than 5 years seems to offer inadequate nominal yield, and maturities of greater than 10 years seem to offer inadequate incremental yield relative to the duration risk. So, to me, an upper-single-digit maturity BBB bond yielding around 5% might be considered a sweet spot of investment grade debt today.

If you think that interest rates are going rip-roaring higher over the near-term (I dont’), then the best way to cope may be to avoid the bond market altogether, holding monies earmarked for the bonds in cash. Of course if you’re wrong and rates don’t move, you’ll suffer opportunity cost by simply holding greenbacks. For the average bond investor, I certainly don’t advocate a timing approach.

In the end, investment grade bonds continue to possess sleep-well-at-night characteristics, but unfortunately don’t offer a lot of reward in today’s market. While there is still value for many to justify investing in them, one needs to have a well thought out strategy for coping with limitations of the space. Further, one must consider risks associated with the various investment grade credit tiers and opportunity costs associated with security duration options.

About the author:

aloisiAdam 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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Comments

  1. Aaron Rivers says

    When was the last time you bought a bond? The chart you pulled from fidelity’s website is ridiculous. Try to find a AAA rated bond that yields 4.80 for 20 years, let alone a tax free bond. Really, yields are so much lower. I do agree that rates are not going up any time soon. The media can’t tell the people the truth and keep their jobs. It’s a shame so many people get their info watching television. Rates will go up to control inflation. What could possibly cause inflation? Millions of people making a lot more money. You might as well start your ladder at ten to thirty years, because a short term ladder will guarantee that you earn the lowest amount of interest possible. Then, ten years from now, your 20 year bonds will be ten year bonds.

    • Adam Aloisi says

      Aaron, thanks for posting. I buy bonds all the time as a component of my overall income strategy, although my overall allocation to them has dropped over the past several years.

      I agree that some components of the chart were a bit optimistic on what one can find in today’s market.

      As I stated in the article, if you were to construct a ladder today, it would have a fairly low blended yield. Your suggestion to go all long is well put, but you must understand the opportunity cost of skewing a portfolio to the long-end and having rates rise precipitously while you are holding the bonds.

      Thanks again for responding to the article,
      Adam

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