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.
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.
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:
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.