A growing number of people are either in or getting close to retirement. Half of the 73 million baby boomers are 65 or older and the other half will reach that age by 2030. This is exactly the time people need to increase their allocation to fixed income investments, usually in the form of bonds. However, the yields paid on bonds are at all-time lows, presenting an enormous challenge. It may be tempting to simply buy riskier bonds with the highest yields or underweight fixed income altogether and pursue dividend-focused stocks. These approaches would overlook the importance of a prudent fixed income allocation. The good news is there are ways to maintain appropriate exposure to fixed income while generating decent cash flow and still managing risk.
How did we get here? Bond yields are at all-time lows in large part due to the Federal Reserve’s response to the Global Financial Crisis and, more recently, their extraordinary policy actions to combat the COVID-19 shutdown. The Fed is messaging that interest rates likely won’t increase in the next 2 to 3 years in order to help nurse the economy back to health. Investors are expecting bond yields to remain historically low for the next few years.
Low rates are not the only challenge facing bond investors. There is currently no central exchange for bonds. Big institutional investors can typically transact the same bond that the small investor can at much better prices. The bond market is decades behind the stock market in this regard because a majority of bonds are still traded over the phone with bond brokers. Also, the sheer number of bonds available and opacity of the bond market make proper analysis difficult for investors, raising the risk of bad outcomes. For 23 years, I was a fixed income portfolio manager for multibillion-dollar portfolios, as well as individual investor portfolios. I know firsthand the many challenges facing smaller individual investors.
Fixed income usually serves two key purposes in a portfolio – to provide a steady source of income and function as a ballast to riskier stocks. The two main risks to always consider when buying bonds are interest rate risk and credit risk. Bond prices typically move opposite of interest rates. Rising rates can reduce the value of existing bond positions. Credit risk represents the potential that a bond issuer will default on their payments of principal and interest. Interest rate risk can be reduced by buying shorter maturity bonds. Duration measures the price change in a bond for every 1% change in interest rates. Naturally, shorter maturity bonds are less prone to price declines than longer maturity bonds. The temptation is to buy bonds with the highest yields. However, consider the example of buying a 30-year maturity Treasury bond at $100 par value that yields 1.76%. If rates increase 1%, that same bond will decline in value by about $20. Furthermore, consider that if inflation averages about 2% a year, the real yield on that bond is negative 0.24%. The below yield curve graph indicates the most attractive area is currently in the 1 to 7-year range given the positive pickup in yield and reduced duration risk. Price declines on under 7-year bond portfolios are not as severe if interest rates increase. Notice how little extra yield is gained from buying a 30-year bond versus a 7-year bond. The most positively sloped part of the yield curve is generally 1 to 7 years.
Credit risk can be reduced by buying bonds rated investment grade by credit rating agencies. Of the three main categories of bonds, Treasuries are considered credit risk-free and coupon payments are federally taxable, but free from state and local taxes. Investment grade corporates, particularly those rated BBB+ to AA are very unlikely to default, yet offer a decent pickup in yield over Treasuries. Tax exempt municipal bonds rated A to AAA also offer an after-tax yield higher than Treasuries, with a very remote likelihood of defaulting. A combination of Treasuries, investment grade corporates, and tax exempt munis (for those in very high tax brackets) are generally the best way to gain exposure to the fixed income market. For those with a higher risk tolerance that want significantly higher yields, below investment grade corporate bonds rated BB or BB+ and preferred stocks are the best options right now.
With all of this in mind, there are ways to make fixed income work well in your portfolio and provide a balance to stocks. The ETF revolution has helped democratize the bond market by giving individual investors access to instant diversification, timing of cash flows, and risk optimization. The small investor with under $1 million to invest in fixed income will have a difficult time gaining diversification using individual bonds without the analytical tools and broker relationships that institutional investors have. ETFs can offer instant access to nearly every fixed income category. Bond ETFs usually replicate indexes or slices of indexes. Some bond ETFs provide exposure to broad indexes of government guaranteed and corporate bonds all in one ETF. Some ETFs are more narrowly targeted. For example, investors can create a bond maturity ladder using investment grade corporate bond ETFs with defined maturity dates. Treasury bond and muni bond ETFs provide safety and negative correlation to stocks. Floating rate bond ETFs can act as a hedge against rising inflation. There are preferred stock ETF options that provide a yield boost. Investors with a higher risk tolerance can buy below investment grade ETFs that provide diversification and opportunities to take advantage of times when the high yield market is oversold. Fixed income can be confusing and complicated. Most people understand stocks and stock markets much better than bonds. Unfortunately, the risks involved with bonds can be just as great as with stocks, especially in this ultra-low rate environment. This will be the first in a series of educational blogs designed to help people understand the often-confusing world of fixed income. Other blogs will focus on: municipal bonds, corporate bonds, preferred stocks, things the fixed income bond pros look at, income generation with stocks, how to replicate an annuity without the high fees, when are the right times to take risk in fixed income, when to buy individual bonds, macroeconomics and inflation, and more.
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Brian Murray MBA, CFA is an Investment Advisor at The ETF Store. He has 23 years of experience as a fixed income portfolio manager for multibillion-dollar institutional portfolios. He helped develop the fixed income department at a $55 billion investment advisory firm where he managed hundreds of portfolios for individual investors.