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Bond Strategy – Don’t Let Interest Rates Get In The Way

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strategy-compass-ssThere are a variety of strategic reasons that bonds are gravitated to as part of an investment portfolio: income production, diversification, and capital preservation to name just a few. But, and perhaps needless to say, few on Wall Street today are pounding the table on the group. Historically low yields, fear of a rising rate environment, and a robust stock market have sought to discourage your average investor from building an allocation to corporate, municipal, or Treasury debt. And I’ll be the first to tell you that it is truly hard to build a strong case today for bonds, at least on a total return basis.

Investors that have less reason to be concerned with returns and possess more of a cash flow/capital preservation mindset, the current market may not be all that imposing, although there has to be an acceptance of lower yield.

To see a list of high yielding CDs go here.

But for those that want to look past the ho-hum environment, there are many reasons to build an understanding of fixed-income and how it can benefit a portfolio, even during this current malaise. So while it may not be prudent to overweight a portfolio with bonds today, you want to be in a position to competently ramp that exposure when the time comes that it would be appropriate to do so.

Bonds, at least when viewed as a total return tool, are most effective when their anticipated returns are seen in excess of other types of investments or as a better “risk-adjusted” alternative. So generally speaking, the best environment for bond owners is one in which generous bond coupons and yields can be found and concurrently when there is a secular environment of falling interest rates. The interim value of a bond is inversely related to interest rate movement. For more than thirty years now, long-term bonds have been a great deal since the general trend in rates has been lower.

US Government 10 year bond

 

For many years now, bond bears have incorrectly cautioned investors about exposure to long-term bonds or any bonds for that matter. At the onset of 2014, for example, with the 10-Year Treasury sitting at about 3%, many felt that it would trend to 4% during the course of the year as the Fed  weaned the economy off of its QE bond buying program. Just the opposite occurred, with rates trending down 100 basis points. So if you had purchased a 30-Year Treasury bond in January of 2014, you would have likely been able to sell it last month at a better total gain than what the stock market provided last year.

But if rates ever do embark on a secular higher climb, the last thing you likely want to own is own a 30- year bond of any kind. Even if you are able to hold to maturity and get your capital back in full, there is an opportunity cost in doing so, since you could have owned bonds with much higher coupons and yields during that three-decade period of time.

I thought one of the best times in somewhat recent memory to be buying bonds was back around Y2K (the year 2000). Growth stocks were grossly overvalued, the 10 year Treasury was about 6%, and very generous yields were available in corporate credit. While I wish I had totally steered clear of the impending disaster that was to hit most growth stocks (I didn’t), it made sense to up bond exposure given the elevated risks that equity markets posed.

Some are of the opinion that equity markets are expensive today, and I agreement with that assessment. However, the “overvaluation,” if we want to call it that, is nowhere near as extreme as it was fifteen years ago. One could certainly argue if that rates stay flat and that equity markets correct by say 25%, that bonds of any sort, even with their lower coupons today are a good risk-adjusted play.

Of course we’ll only know in hindsight if the decisions we make today are the best ones we could have made. Plotting strategy and making the best allocation decisions we can with the data that we have is all we can do in the present. So while now may not be the best time to buying bonds with pure abandon, another Y2K-like opportunity may come going forward. And you’ll want to be ready for it.

aloisi

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.

 

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Adam Aloisi

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.

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