A winning fixed-income formula
The Federal Reserve continues to make headlines over the question of when it will begin to “taper” the current quantitative easing (QE3). Many investment pundits are suggesting that investors should forego any fixed income (bond) investments. Because the key to successful long-term investing is a diversified portfolio, getting totally out of fixed income investments does not seem prudent. By being sensitive to current market conditions, it is possible to structure a profitable fixed-income portfolio.
One of the most significant risks to bonds and bond funds is rising interest rates. Long-term bond funds have performed exceptionally well over the past 20 years as interest rates were falling. The same factor (duration) that allows longer term bond funds to outperform shorter term bond funds when interest rates fall makes longer term bond funds more vulnerable to losses when interest rates rise.
Every bond and bond fund has an effective duration. Duration is the measure of the sensitivity of a bond fund’s price to a change in interest rates. For every one year of duration, a bond fund will lose 1 percent of its value as interest rates increase by 1 percent. Thus, a bond fund with a10-year duration will lose 10 percent of its value if interest rates rise by 1 percent.
To protect from excessive interest rate loss, invest only in low duration bonds and bond funds. The fixed income portion of your portfolio should also be well-diversified. Search for low duration and higher yielding bond funds throughout a diversified spectrum of fixed income investments.
A diversified fixed income investment portfolio could include the following:
1. A total return bond fund yielding 5.11 percent with an effective duration of 3.52 years. Interest rates would have to rise almost 2 percent in a year for yearly total return to be negative.
2. A high yield bond fund with a 6.3 percent yield and an effective duration of 3.16 years. High yield bond funds are less sensitive to interest rate risk. They tend to hold their price when the economy is reasonably strong even as interest rates rise. However, when the economy weakens, be wary of high yield bond funds.
3. A well-diversified foreign bond fund with a 5.44 percent yield and a 1.59 year duration. Foreign investments are a critical part of a diversified portfolio. Interest rates in other countries are not tied to US interest rates. A well-managed international bond fund portfolio can often avoid countries with high interest rate sensitivity. At this point, we advise caution with emerging market bond funds. Many emerging market countries have both increasing interest rate and inflation volatility, making these funds too volatile for most investors.
4. A short term corporate bond fund yielding 2 percent with a 2.89 year duration. While corporate bond funds do have interest rate risk, investment grade corporate securities have minimal credit risk and should do well, even as interest rates slowly rise.
We do not currently recommend any allocation to Treasury Inflation Protected Bonds (TIPS). With the measured inflation rate low and expected to stay so for the foreseeable future, owning a TIPS bond fund offers very little upside.
On a year to date basis, the iShares Core Total US Bond Market ETF (AGG), has had a total return of -1.83 percent, with an average duration of 5.1 years. In contrast, a fixed income portfolio that is equally allocated to the bond funds listed above has had a year to date total return of +1.22 percent and has an average duration of 2.79 years. Even in a rising interest rate environment, with a well-diversified, short duration portfolio, bond funds can still provide a positive return.
While there is no guarantee that bond funds will continue to increase in value, especially as interest rates continue to rise, a well-diversified portfolio should always have at least a 25 percent allocation to fixed income investments. A well-diversified bond fund portfolio will provide significantly less volatility than equity funds and, over the long term, provide an excellent total return, if properly managed.