In January the Federal Reserve announced its intention to keep interest rates near zero percent at least through late 2014. That may be beneficial to the economy at large, but the news was not so good for the conservative investor who might have moved a sizeable chunk of his assets out of stocks and into bonds in a search for security.
In hindsight that was a clever move because not only are bonds less volatile than stocks but their value has risen steadily with the decline in interest rates. But with interest rates at historic lows, those gains won’t—in fact, almost can’t—continue, says Dirk Hofschire, senior vice president of asset allocation research for Fidelity Investments. He predicts that the safest bonds—U.S. Treasuries—are likely to pay just enough in the next decade to keep up with inflation.
Time to get out of bonds? Not so fast, says Hofschire: “The situation argues for realistic expectations not for the abandonment of bonds, and perhaps a portfolio with a good mix of bonds still has much to offer.”
The key word here is “mix.” If Treasuries are paying a paltry two percent, the strategy calls for diversifying. Bonds come in all flavors, just like stocks do.
“Complementing high-quality bonds with a variety of other sectors can help you increase your yield and return potential while protecting against risks such as potentially higher inflation,” says Hofschire.
Treasury bonds are available in both conventional form (with steady coupon payments) and inflation-adjusted (lower, fixed coupon payments but regular adjustments for inflation). Include both in your portfolio. In addition, consider the following:
• High-quality, “investment-grade” corporate bonds. These typically yield about 1 percent a year more than Treasuries.
• Municipal bonds. Historically, bond issues by cities and state governments haven’t paid as much as Treasuries. But right now they are about on a par—and, of course, the difference is that interest on municipal bonds is generally tax-free, making their effective return greater than Treasuries.
• Corporate high-yield bonds. Issued by less-than-financial-powerhouse companies, these bonds are riskier than the others mentioned above but are now paying about 3 percentage points a year more than Treasuries.
• Emerging-market bonds. Issued by countries such as Brazil, Russia, and Turkey, the bonds are now yielding a rate similar to corporate high-yield. These, too, carry risks, but offer good diversification power.
Within each bond sector you can further diversify by choosing a mutual fund or exchange-traded fund that allows you instant ownership of hundreds or more of individual bond issues. The strategy is crucial when investing in options like high-yield (aka “junk”) bonds, where the default of any one bond is more than a remote possibility.
Finally, it may be time for even the most conservative investor to venture cautiously into other areas. Consider lowering your bond exposure by investigating vehicles that pay higher interest rates, says David Lambert, founding partner and wealth advisor with Artisan Wealth Management of Lebanon, New Jersey. “For many of our clients we have lowered the overall allocation of bonds and replaced them with other income-producing holdings such as real-estate investment trusts and dividend-paying stocks.”
But sound money management will always dictate holding some bonds. As Lambert points out, even the largest and most stable stocks tend to be more volatile than bonds.