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Are You Really a “Long-Term” Bond Investor?

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long term bond investingWhen it comes to investing, there are millions of people who would describe themselves as “long-term investors.” This description generally refers to someone who has a time frame of many years (think decades) and is willing to ride the ups and downs of the financial markets. While I hear this phrase most often used regarding equity investors, it can apply to fixed-income investors as well.

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One of the great things about investing in individual bonds is that, absent a default by an issuer, the bonds will mature at par. This allows investors the luxury of riding out lower prices without ever having to wonder whether the security will recover. From my perspective, individual bonds provide investors with a wonderful opportunity to become true “long-term investors,” buying and holding securities that they know with a high degree of confidence will meet their specific goals over extended periods of time. And yet, I constantly read about people shunning intermediate- to long-term individual bonds because of the persistent fear that rising bond yields will harm the mark-to-market value of their investments. It is one thing to say that you don’t want to buy bonds at today’s prices because the yield and credit risk aren’t suitable for your portfolio. But it is another thing to avoid bonds that do meet your yield and credit risk criteria because you are afraid of the so-often discussed but yet-to-occur “Great Rotation” or “crash” in the bond market.

A worthwhile exercise for every bond investor is to figure out what type of yield they ideally would want to achieve from their bond investments. Of course, anyone can say 10% or 20%, but let’s keep things realistic from a very long-term historical perspective. If you could build a bond portfolio of acceptable credit risk that yields 5%, would that be sufficient? How about 6%? Or 7%? Once you determine the long-term return you are hoping to achieve from a diversified individual bonds allocation, the trick is to find those bonds without taking on more credit risk than you are comfortable having.

What if I told you that in the corporate bond market today, despite historically low yields, you can find bonds with moderate credit risk that yield more than 5%? I bet a lot of investors would be interested in that. Now, what if I told you that in order to capture those yields, you needed to purchase bonds with 25 to 30 years to maturity? This is the point at which I think a lot of bond investors would say “Forget about it.” I certainly do not advocate putting 100% of your portfolio in long-duration bonds. But if an investor can get a desired yield at an acceptable credit risk using individual bonds, why wouldn’t a “long-term” investor have an allocation to longer-duration individual bonds?

Nobody knows for sure if or when benchmark Treasury yields will head much higher from today’s levels. We have already been waiting years for that to happen, and an argument can certainly be made that we will have to wait many more years. The longer you wait for yields to head higher without buying bonds that meet your yield and credit risk criteria simply because they were longer-duration bonds, the higher the opportunity cost of missing out on the yields you could have had but failed to jump on. In fact, if you end up waiting five, ten, or fifteen years to purchase short- to intermediate-duration bonds at the same yields you could have had on longer-duration bonds several years earlier, you will eventually learn that you are very likely to end up with less money in the long run. For investing time frames of 20, 30, 40, or even 50 years, true long-term investors wouldn’t allow acceptable yields and credit risk on individual bonds to go unpurchased.

Today’s environment for fixed-income investors looking to put money to work is about as challenging as anyone has likely ever seen. But if you can tolerate the price swings that will occur over a multi-decade time frame, you can still find bonds today yielding more than 5% with what I view as moderate credit risk. For some investors, 5% to 6% yields may be all they are hoping to get out of a bond portfolio over a multi-decade time frame.

If the possibility of slowly building a portfolio of longer-duration bonds at 5% or more yields interests you, keep the following tidbits in mind:

1. If you are nervous starting several positions in longer-duration bonds (remember to first figure out the appropriate percentage of your portfolio to allocate to such bonds), consider buying a little at a time, just as many investors do with stocks. Dollar-cost averaging or adding to a position on a dip also works in the world of bonds.

2. You can certainly use any type of inflation rate you find realistic when figuring out what type of real return you can live with from your bond allocation. Keep in mind that many financial planners will assume inflation rates in the 2.25% to 3% range during the planning process. This is important to remember given that many financial planners/advisors who have a preference for stocks will broadly mention inflation and taxes as reasons to avoid bonds but only assume future inflation rates of 2.25% to 3% when making future projections about portfolio values.

3. Speaking of taxes, remember that the tax bracket into which you fall is not the tax rate at which 100% of your income is taxed. From conversations I’ve had with everyday people about taxes, I have a feeling there are a lot of investors who don’t realize just how low their actual tax rates are. Take a look at your most recent tax return, take the amount of tax you paid, and divide it by your gross income. If you thought your tax bracket was the rate at which all your income was taxed, you will likely be pleasantly surprised by just how low your actual tax rate is. Keep your actual tax rate in mind when calculating after-tax and after-inflation returns on your bonds. I have a feeling a lot of people are going to discover an actual tax rate of less than 25%, and in many cases far less than 25%.

If you are a true “long-term investor” with a multi-decade time horizon, don’t shy away from individual bonds that meet your yield and credit criteria simply because they have many years to maturity. Remember that absent a default, those 25 to 30 year bonds will one day turn into five year bonds, one year bonds, and eventually a bond that has matured at par.

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