Although some of these common tacks seem sensible, they have drawbacks, too.
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By Christine Benz | 01-16-14 | 06:00 AM | Email Article

Given that they're often considered the safe, boring part of investors' portfolios, bonds have certainly produced more than their fair share of angst over the past few years. Having enjoyed the tailwind of declining yields for nearly three decades, many bond investors have been fretting about the day when that tailwind would become a headwind. 

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

Those fears were stoked in the summer of 2013, when Federal Reserve Chairman Ben Bernanke hinted that the Fed could begin to scale back the bond-buying program that had suppressed bond yields since the financial crisis, and consequently provided a glimpse of what a period of rising rates could mean for bonds. Not surprisingly, long-term Treasury bonds took it on the chin, dropping 6% during the second quarter and shedding another 6% in the second half of the year. Categories such as emerging-markets bond funds proved quite rate-sensitive, too.

Against this uncertain backdrop, investors have been mulling--and executing--a variety of strategies to help protect their portfolios against rising bond yields. Morningstar's fund flow data show that they've been shortening up, embracing credit-sensitive bonds, and eschewing bonds altogether in an effort to defend their portfolios against rising rates. Yet even as such strategies might seem eminently sensible given that bond yields have much more room to move up than they do down, all of these tacks carry drawbacks of their own. Here's a rundown of the key benefits and pitfalls of some of these strategies.

Shortening Up
The Strategy: At first blush, the notion of moving into cash or short-term bonds in lieu of more rate-sensitive securities looks like the biggest no-brainer out there. Rising interest rates have the potential to crunch long- and intermediate-term bonds, whereas short-term bonds would likely be much less vulnerable in a period of rising yields. Using the duration stress-test discussed here, the typical intermediate-term bond fund would stand to lose about 3% of its value if interest rates jumped up by 1 percentage point over a one-year period; the typical long-term fund would lose about 9% or even 10%. The average short-term fund, meanwhile, would lose about 1%, and cash (CDs, money market funds, etc.) would remain stable.

The Risks: As investors who shortened up a few years ago know well, there's an opportunity cost to hunkering down in ultra-low-yielding cash and short-term bonds. Even though interest-rate jitters were alive and well three years ago, the typical intermediate-term bond fund has gained nearly 2 percentage points more, on an annualized basis, than the average short-term bond fund since early 2011. That risk is arguably more in the rearview mirror than it is a concern on a forward-looking basis. A bigger consideration, however, is how to know when to get back into intermediate-term bonds once you've exited them. After rates have risen three percentage points? Four? Moreover, as Morningstar senior fund analyst Eric Jacobson discussed in this video, cash and/or short-term bonds, even high-quality ones, may not provide the same ballast for the equities in one's portfolio that intermediate- or longer-term bonds will tend to do. True, short-term bonds won't tend to go down much, if at all, in an equity-market shock, but nor are they likely to gain value during such a period, either.

Buying Individual Bonds
The Strategy:
Forget bond funds. What about simply buying and holding individual bonds to maturity? Whereas the holder of a bond fund could incur principal losses if interest rates go up during a given holding period, the investor in a high-quality bond would receive his or her principal value back, even if yields jumped up substantially during that period.

The Risks: As with shortening up, the investor in individual bonds faces potential opportunity costs. By locking in today's relatively low rates, the individual-bond investor who's buying and holding won't have the opportunity to swap into higher-yielding bonds if and when yields pop up. Funds, meanwhile, have bonds maturing all the time and therefore have the option to trade into higher-yielding securities as they become available, even though they may take a hit to their principal values as yields rise. And although buying individual government bonds or corporate bonds issued by the AAA rated companies is a reasonably safe strategy, smaller investors venturing beyond gilt-edged bonds may have trouble conducting adequate research on such credits and assembling a portfolio with adequate diversification. Trading costs can also be an issue for small investors. I discussed these and other issues to keep in mind before supplanting funds with individual bonds in this article.

Tilting Toward Credit Sensitivity
The Strategy: Another tack bond investors have been taking lately has been to venture into more credit-sensitive bond types in lieu of higher-quality fixed-income funds. Bank-loan, unconstrained bond, and, to a lesser extent, high-yield bond funds have been seeing massive new inflows, even as investors have hit the exits at traditional core bond funds such as  PIMCO Total Return . Credit-sensitive bonds have higher yields attached to them than higher-quality bonds, and that yield provides a better cushion in a period of rising rates than high-quality bonds have. Bank-loan funds have an additional level of imperviousness in a period of rising rates, in that their yields adjust upward to keep pace with prevailing rates. Buyers of lower-quality credits can also take comfort in the fact that the economy seems to be recovering, so broad-scale defaults are unlikely. 

The Risks: Even though it's not unreasonable to assume that the economy will continue to mend, and that will serve as a positive for lower-quality credits, there's always the risk that the economy could experience a hiccup or worse, which would tend to depress the prices of lower-quality bonds. And while such bonds typically offer higher yields than higher-quality credits, that yield differential has narrowed considerably over the past few years. For example, the yield spread between the Bank of America Merrill Lynch High Yield Index and Treasuries was recently 3.92%--not as low as it got in late 2007 (about 2.5%) but certainly low relative to historic norms. Perhaps an even bigger issue is that lower-quality bonds may not fulfill one of the key roles investors look for bonds to fill: diversification. I discussed that issue in this article

Buying Dividend-Paying Stocks
The Strategy: With bond yields as depressed as they've been, dividend-paying stocks have emerged as a compelling alternative for many investors, offering yields that are competitive with or in some cases higher than high-quality bond yields. Right now, for example, the yield on the Barclays Aggregate Bond Index is just about 30 basis points higher than that of the S&P 500, and it's not hard to find high-quality companies with yields that are much higher than the S&P's. Investors in dividend-paying stocks can also benefit through share-price appreciation and if companies increase their dividends.

Cons: The biggest drawback to using income-producing equities to supplant fixed-income securities is volatility. The median equity fund with a dividend focus has a five-year standard deviation of about 15, whereas the typical intermediate-term bond fund has a standard deviation of just 3. Long-term dividend-focused investors might say they're unperturbed by short-term volatility, but if they're relying on their portfolios for dividend income and their payouts and/or emergency fund don't cover an unplanned expense, they could be forced to raid their principal when it's at a low ebb. Moreover, while income-producing stocks aren't as directly affected by interest-rate changes as are bonds, they're not impervious, either. The past summer's interest-rate shocks caused shudders across a host of income-producing equity sectors, especially utilities, as discussed in this article.

See More Articles by Christine Benz

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