Adding Bonds To Your Portfolio

By: Frank Armstrong, CFP, AIF
Bonds are typically issued at par, redeemed at par, and along the way they fluctuate in value as prevailing interest rates change. Their total performance closely tracks inflation expectations. So real growth–if any–is too small to be meaningful. Investors often view them as safe, but the volatility of long-term bonds may be as high as that of stocks, while their return per unit of risk is anemic in comparison. To add insult to injury, long-term bonds have a high correlation to other financial assets, and they perform abysmally during periods of high inflation.
All in all, the characteristics of bonds as an asset class are so dismal that you might wonder why any investor would want them at all. Of course, not all investors have similar needs. Many institutions are more interested in matching future liabilities with assets than maximizing total return. For instance, life insurance companies can estimate their future liabilities with some precision. Having bonds that mature on schedule allows them to match assets with expected requirements. Statutory regulations require them to hold bonds to back up their obligations. To oversimplify, insurance companies mark up the cost of providing benefits to compute their premiums. Total return isn’t as important as the spread.
That’s not the situation we face as individual investors, though. We want to maximize our return per unit of risk, and bonds don’t fit in very well. If we plot the risk/reward points for several well-known long-term bond indexes from 1978 to 1997, we see that they all fall far below the standard risk-reward line. Not a pretty sight, is it?
Over the 20-year period, various classes of bonds all land well below the risk-reward line between T-bills and the S&P 500 index.
Bonds have only two useful roles to play in our asset allocation plans: They can reduce risk to tolerable levels in a portfolio, and they can provide a repository of value to fund future expected cash-flow needs. Of course, we don’t expect the bond portion of the portfolio to be a dead drag on its overall performance. It makes sense to take prudent steps to enhance returns in every portion of the portfolio. Let’s take a look at some of the common methods employed by fixed-income investors to see if any might advance that goal.
Junk Bonds
Investors take on more risk when they invest in lower-quality bonds. While they can increase total return as they move from government bonds to corporate to high-yield (junk), investors simply don’t get paid enough to justify the risk. They remain hopelessly mired below the risk-reward line.
Active Trading
We all know that the capital value of a bond whipsaws as interest rates in the economy change. So, if we had an accurate interest-rate forecast, we could develop a trading strategy to reap capital gains. Buying long-term bonds before interest-rate declines will produce gratifying profits. Pretty simple, huh? The trouble is, accurate interest-rate forecasts are elusive. Seventy percent of professional economists routinely fail to predict the correct direction of rate movements, let alone their magnitude.
Individual bond selection suffers from the same problems as equity selection. The market is efficient, and finding enough mispriced bonds to make the effort worthwhile is problematic. It shouldn’t surprise us that traditional active management of bond portfolios fails every bit as profoundly as does active equity management.
Riding Down the Yield Curve
Borrowers generally demand additional return for holding longer-maturity bonds. The relationship between maturity and return is expressed as the yield curve. When longer-maturity bonds have higher yields, which is most of the time, the yield curve is said to be positive. As you can see in the graph below, yield typically rises very gradually, while risk takes off sharply beyond a one-year maturity. On a risk/reward basis, bonds with maturities of more than five years are generally not attractive at all. Hence, investors are well advised to confine themselves to the short end of the spectrum.
As a bond’s maturity increases, the slope of the risk line is much steeper than the slope of the return line.
However, a simple passive technique that I call “riding down the yield curve” can improve yields at the short end of the curve. If the yield curve is positive, simply purchase bonds at an optimum point where interest rates are high, hold them until an optimum point to sell at a lower rate. This captures both the yield on the bond while it is held, and a capital gain on the difference in price. During the few times when the yield curve is not positive, simply hold short-term bonds. Nothing is lost because the rates are higher here anyway. While the procedure involves trading, it does not require any type of forecast to be effective. The yield curve is simply examined daily to determine optimum buying and selling points. To be effective on an after-trading-costs basis, only the most liquid bonds (U.S. Treasury and high-quality corporate bonds) can be used. Over time, a bond portfolio with an average duration of only two years might be enhanced by 1.25% by using this technique.
Foreign Bonds
In theory, at least, the biggest reason for yield differences between foreign and domestic bonds is currency risk. If you were to fully hedge currency risk, you should theoretically be right back at the T-bill rate. But in real life, opportunities exist to buy short-term foreign-government bonds, hedge away the currency risk, and still have a higher yield. Taking advantage of these “targets of opportunity” can further enhance a short-term bond portfolio, perhaps by a percentage point or two. Of course, if there are no such opportunities during a particular period, just buy domestic bonds.
Retirees occasionally believe that they can solve the entire reinvestment problem by laddering a bond portfolio so that some of their bonds mature each year. These bonds are then rolled over at the current interest rate. In theory, this strategy avoids reinvestment risk because–over the course of the cycle–some bonds will mature at times of high rates while others will mature at lower rates. Proponents of this strategy argue that there is no capital risk because the bonds will mature at par when needed. Of course, they are simply closing their eyes to the changes in value. The portfolio still holds a big block of inefficient assets, and the expected return is not enough to meet any reasonable economic need of the retiree.
Muni Bonds
Municipal bonds hold a special fascination for many investors. However, their tax-free status obscures what is perhaps the worst risk-adjusted performance of any class of bonds. Equivalent returns for municipal bonds can be calculated by simply dividing the municipal bond rate by one minus the taxpayer’s marginal tax rate. For instance, in our first graph, the 20-year annualized return of 7.36% for long-term muni bonds is equivalent to a fully taxable rate of 12.19% for a taxpayer in the 39.6% tax bracket:
7.36 / (1 – .396) = 12.19
We’ve slightly exaggerated the tax-free rate of return, as only the income portion of the bonds’ total return is exempt from taxes, but even when we plot this “grossed up” equivalent rate we still get a point that is the furthest from the risk-reward line of any bond type.
Short-term municipal-bond money market instruments also look like a poor deal. According to the Wall Street Journal, a recent average seven-day compound yield on tax-free money market funds of 2.84% computes to an approximate 4.7% equivalent yield for a 39.6% taxpayer, compared with a 5.02% average yield for taxable funds. The 39.6% federal tax rate, however, doesn’t apply to married couples or single taxpayers until their taxable income tops $278,000. Few of us are in that fortunate position. Therefore, most muni-bond investors seem to be paying a high price for tax avoidance.
Additional investment risk should only be taken when there is a strong expectation you will be rewarded for the added risk. As we have seen, bond investors are generally poorly compensated when they take on additional risk. So, it makes sense for us to keep the bond portion of our portfolio restricted to short-term, high-quality issues.

By | 2018-11-28T23:47:03+00:00 September 18th, 2012|Blog|

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