Thinking Strategically About Bonds

strategyEarlier this week, The Financial Lexicon posted a worthwhile article on LearnBonds that provided comparative perspective on investing in stocks with low yields but growing dividends versus investing in bonds with higher interest rates. For investors whose prime focus is income, scrutinization of all security options and consideration of one’s time horizon is an absolute necessity in today’s difficult low interest rate environment.

  To see a list of high yielding CDs go here.  

Though I think the flexibility of being able to buy different kinds of bonds with varying tax ramifications, maturities, credit ratings, and coupons makes them potentially worthwhile in just about any investor’s portfolio, I would certainly not push the asset on everyone. Indeed, in today’s environment, the total return potential of bonds now compared to thirty years ago is negligible. And with the threat of higher interest rates looming, the opportunity costs of investing in long duration bonds with high coupons could be much more than negligible.

When one considers and researches bonds, one must go about the endeavor in a strategic manner. While perhaps not an iron fast rule, the younger one is, the less bonds one should own. But for someone with high risk tolerance and a drastic need to grow capital, even an older investor, bonds might be taken out of the equation altogether.

For everyone else, from your income seekers to your capital preservationists, bonds can certainly fill a role in a portfolio. As someone who vehemently dislikes wholesale allocation blueprints and rules of thumb when it comes to portfolio construction, I would recommend throwing out the textbook and getting into the trenches. This would mean taking the time to seriously dwell on whether a dividend stock with a puny, but growing, 2.5% yield and capital appreciation potential trumps owning a 6% fixed yield bond over 25 years.

It would also include dwelling on what happens to that 25 year 6% bond if and when rates rise. Would you be devastated to see the value of that bond decline substantially on your monthly statements even if you plan on holding it to maturity? If so, you need to consider shortening up maturities or perhaps developing a bond ladder that takes the emotion out of the guessing game that the forward rate environment might bring.

I would also recommend becoming familiar with the current yield on the 10-year Treasury bond. Not only does it give you an idea of what intermediate risk-free yield is in the fixed income market, it also provides historical perspective and understanding of what has and is currently occurring in the bond market. Below is a 10-year historical chart of the 10-year’s yield.

While the 10-year has traded in a range of roughly 2-5% over the past 10 years, one can clearly see the flight to bonds in the winter of ’08/Spring of ’09 and last year’s bond sell off prompted by the Fed’s inclination to begin a bond buying taper.

If you bought an intermediate to long-term bond over the past two years and are wondering why the value of that bond has gone down precipitously, this chart provides you with your answer.

Contrary to some of the more bearish commentary prevalent in today’s press, I don’t think that bonds on a wholesale level are in a bubble or are an asset worth ignoring or passing over. However I would caution that investors buying into long-term paper should have clear rationale for doing so and understand the implications of interim pricing when rates trend higher. In my opinion a bubble could currently exist in long bonds if rates decide to march precipitously higher over the near-term. I personally don’t see that happening, but it is certainly possible.

Thus, income seekers and capital preservationists should carefully consider their strategic options both in- and out of the bond market prior to pulling the trigger on any individual bond or bond-related product. Time horizon, risk tolerance, income need, amongst other variables should all be part of the thought equation. While not every investor has a need for bonds, the heterogeneous nature of the asset class provides a variety of solutions for most who do.

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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