By Brenda Wenning/local columnist
The MetroWest Daily News
Posted Aug 15, 2010 @ 12:04 AM
Mention investments and the first thing most investors think of is stocks. Bonds are the poor stepchild, often ignored or overlooked.
They may not offer the sometimes spectacular results that stocks provide, but they are also unlikely to cause the huge drops in value that stock investors have endured. They can be a steadier contributor to your investment portfolio. Ideally, they are not a substitute for stocks, but a complementary investment, providing diversity and stability, in addition to income and long-term returns.
With interest rates at historic lows and the possibility that they may rise soon, it may seem like an odd time to think about investing in bonds. After all, when interest rates rise, bonds drop in value. But even in today’s economy, bonds can provide opportunities, especially for risk-averse investors.
The many faces of bonds
Many investors lack an understanding of bonds, which typically are issued to finance capital projects, either by government agencies or by corporations. Bonds are "fixed-income" securities. Their value fluctuates, but they also pay income on a regular basis and the income rate stays the same until the bond matures.
Government bonds include municipal bonds, or "munis," which finance local projects, and three types of bonds issued by the federal government - long-term Treasury bonds, short-term Treasury bills and medium-term Treasury notes.
Government bonds do not offer high returns, but they are low-risk investments and provide tax advantages, such as exemption from state and municipal taxes.
Corporate bonds can provide higher returns, but they are riskier and do not provide tax advantages.
Mortgage-backed securities (MBS) are another type of bond, but one that proved to be far riskier than anticipated, becoming the central cause of the financial crisis of the past few years.
To determine how risky a bond is, investors can check its rating, although keep in mind that the rating agencies typically gave MBS very high ratings before they defaulted.
A bond with a B rating or lower is typically referred to as a "junk" bond. It may pay a higher "yield" than bonds with a higher rating, but it also carries a higher risk of defaulting.
Bond investment strategies
So how should bonds figure into your investment strategy?
Here are a few examples:
Alternative to "cash equivalents." Spooked by volatility, many investors have parked their savings in money market funds and certificates of deposit, even though the interest rates these cash equivalents are paying are at record lows.
Short-duration, high-quality bonds and bond funds are a better alternative for risk-averse investors. They can provide a yield that beats CDs and money market funds and they carry little risk.
Source of income. Investors who are willing to accept greater volatility in return for more income should consider investing in "spread sector" bonds. Spread sector bonds include all bonds that provide higher yields than Treasuries; the difference is referred to as a "spread." While spread sector bonds carry more risk than Treasuries, their higher yields provide a hedge against downside risk.
In addition, with the exception of MBS, spread sector bonds are less sensitive to changes in interest rates than Treasuries.
Corporate bonds, MBS and government agency bonds typically outperform Treasuries as the economy improves. Economic growth increases revenues and improves credit quality. Think the financial crisis is fading and the economy is improving? If so, spread sector bonds may be appropriate for you.
Diversification. As part of an asset allocation strategy, bonds can reduce overall risk and volatility, which should lead to higher long-term returns. As with stocks, diversification can reduce risk and increase returns long-term. When one type of investment performs poorly, another type of investment is likely to perform well, which will help to offset losses and potentially provide a higher long-term return.
For example, balancing investment-grade bonds with less creditworthy, but higher yielding bonds may provide higher returns over time. Likewise, consider balancing corporate bonds and government bonds, including U.S. Treasury and municipal bonds.
Laddering and barbells
In addition to diversifying among different types of bonds, investors should consider diversifying among bonds with different maturities.
One way to diversify maturities is to use a technique called "laddering," which can reduce your portfolio’s exposure to interest-rate risk. To build a laddered portfolio, you purchase bonds that mature throughout a set investment period. For example, if your investment period is 10 years, you may buy five bonds with maturity periods of two, four, six, eight and 10 years.
When the first bond matures, you replace it with a 10-year bond, maintaining your ladder by adding another rung at the end of your ladder. By laddering your portfolio, you are spreading your risk over not only different time periods, but different interest rates.
Bonds with short-term maturities have a high degree of stability but provide a lower yield than long-term bonds. Long-term bonds provide higher yields, but are very sensitive to changing interest rates. By laddering your portfolio, you will earn a higher return than if you were only invested in short-term bonds, but have less risk than if you were only invested in long-term bonds.
You will also have greater liquidity than if you were investing only in long-term bonds, as at least one bond in your portfolio will mature every year or two, depending on how you build your ladder.
Keep in mind that this is a long-term strategy and does not take the current interest-rate environment into account.
Although not recommended during the current interest-rate environment, an alternative to laddering your portfolio that may be considered in the future is a "barbell" strategy.
Using a "barbell," the investor concentrates bond holdings at both ends of the spectrum. A high percentage of investments goes into short-term bonds, typically with maturities of a year or less, and a similar percentage goes into long-term bonds, typically with maturities of 20 to 30 years.
A barbell strategy is especially effective when there is uncertainty about whether interest rates are heading up or down. If they’re heading down, long bonds are a good investment. If they’re heading up, shorter maturities are better.
Concentrating investments on both ends of the spectrum returns your risk, whether rates go up or down.
Given that interest rates are at historic lows and that interest rates are expected to increase, this strategy is currently not recommended.
Remember that bonds are not without risk. An in-depth knowledge of bonds is needed to invest successfully long-term.
Bonds are not nearly as exciting as stocks, but, given recent market volatility, wouldn’t it be refreshing to have a little less excitement in your portfolio?
Brenda P. Wenning of Newton is president of Wenning Investments LLC of Newton. She can be reached at Brenda@WenningInvestments.com or 617-965-0680. For additional information, visit her blog at www.WenningAdvice.com.
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From The Daily News Tribune published on Aug 15, 2010 @ 12:04 AM