Similar to the equity strategist who likes to predict where major stock market indexes will sit come the end of the year, many bond prognosticators will offer their thoughts on what will happen to interest rates during any given twelve month period. Last year, for instance, with the 10-Year Treasury sitting at around 3%, many pundits were predicting a potential move towards the 4 percent mark. Had you heeded that advice you might have sat on cash or worse yet, shorted (bet against) bonds. Buying longer-term Treasuries last year was a much more lucrative move than investing in an equity index, as long rates slowly meandered lower — surprising many — during the course of the year.
Though short-term, and longer-term predictions for that matter, make for interesting water cooler talk and chit-chat on CNBC, more often than not, the pundits are wrong. Which is not necessarily to say that some can’t be right or close to right or that you shouldn’t follow pundits with good track records. However, unless you are investing in bonds for short-term gains or merely as a trade, trying to time things may end up costing you in the long run.
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For the conservative bond investor simply looking for a cash flow stream, I would argue that it makes little sense to churn a portfolio based on interest rate speculation. Creating a bond ladder that totally takes bond prediction out of the equation, or making point in time purchases with an attempt to buy the “sweet spot” of yield, are far more conservative and arguably, rational, ways to buy bonds.
A bond ladder staggers portfolio maturity with various “rungs” that elicits the purest of market agnosticism. If you buy 10 bonds, with one maturing every year, and buy a 10-Year bond every time one of your bonds matures, you have created a portfolio with 5-year blended yield and access to capital every year. To keep the ladder in tact, you would roll matured paper into another 10-Year bond.
You can create ladders with longer maturities to create greater blended yield. To generate more yield you could buy 15 bonds maturing every 2 years, then buy a 30-Year bond every time a bond matures.
An alternative to the agnostic bond ladder is analyzing bonds in an attempt to find the “sweet spot.” The sweet spot is a bond with credit and maturity that offers maximum risk-adjusted yield for the price. For instance if you can buy a 10-year BBB bond with 50 basis points more of yield compared to say an A-rated bond, that may be worthwhile. It may not be worthwhile to look at a 20-Year bond that yields only 50 basis points more than a 10-Year bond. If rates go up, the 50 basis points of extra yield could quickly be extinguished. Of course if rates do not go up, then buying the extra yield would turn out to be a good bet.
In any case, putting some level of macroeconomic thought and yield curve analysis into purchases is certainly worthwhile in an attempt to find a quality bond. In my own portfolio, I’ve been finding “sweet spot” yield for some time now with credit in the BBB/BB “area” with upper single digit (5-10 year) maturity.
To sum up, I would opine that the average bond investor should not try to get into too much of a guessing game on where rates head over the near-term. Either constructing a bond ladder or some “sweet spot” thinking may be your best bond-buying strategy as we continue to wade through these unusual economic times.
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.