Article from http://www.marketwatch.com/story/
May 11, 2013, 7:01 a.m. EDT
Time to re-evaluate definition of fixed income
The pundits would have us believe that the bull market in bonds is over. That bond prices have nowhere to go but down and yields up.
Case in point: Berkshire Hathaway BRK.A +1.01% BRK.B +1.05% Chairman and Chief Executive Warren Buffett told CNBC this week that bonds are “a terrible investment” right now. And Loomis Sayles’ Dan Fuss earlier this year said the fixed-income market is more “overbought” than at any time in his 55-year career.
Overbought and terrible investments as bonds might be, the market doesn’t seem as convinced. Consider, for instance, the yields on Treasury Inflation Protected Securities, also known as TIPS. Those that mature in five years yield -1.28% while those that mature in 10 years yield -0.48%. See Daily Treasury Real Yield Curve Rates.
In other words, bonds might not be the best investment, but the looming bond losses predicted by Fuss, Buffett and others might be a long way off. If that’s the case, what should those planning for or living in retirement do with the money they’ve allocated to fixed-income securities?
And, what if Buffett, Fuss, and others are right in their assessment, that bonds are a terrible investment? What then? Buy, sell, hold or hide your head in the sand? What’s a retiree or retirement saver to do?
In the main, advisers we interviewed agreed with Buffett and Fuss. They say the great bull market in bonds is over, though it might be a while before the bear market begins. Call it a holding pattern with the best bet being avoid or sell long-term bonds.
For instance, William Suplee IV, president of Structured Asset Management, says there are few reasons to own long-term bonds, or TIPS for that matter. “Bonds have run the full cycle from 1950 to 1982 and back till today,” said Suplee. “There is almost nothing left in the long end with one big exception.”
And that exception is this: Should there be a Japanese-style long-term deflationary spiral then long bonds are still a good investment. “But that’s only under that type of scenario and it doesn’t look that probable,” Suplee said.
As for TIPS, Suplee said those investments are “fully priced” and the only reason to hold them now is as an inflation hedge. “If we have big inflation they will help, but not as much as you would wish because of the pricing,” he said. “The real yield will be below inflation.”
Another manger is of the same opinion. “We wouldn’t touch TIPS at these prices,” said Christopher Pavese, the chief investment officer at Broyhill Asset Management.
In the event of hyperinflation, however, Suplee said TIPS will be like gold as a store of purchasing power except for the fact that they have poor tax consequences. “TIPS are taxable and don’t throw off cash flow,” he said. “Ouch?”
(TIPS, for those for whom such instruments are a prudent investment, are best owned in qualified accounts, he said.)
But no matter whether you own TIPS in a taxable or tax-deferred account, Suplee said, the day is dawning when it will be time to get out of them. “Keep durations short,” he said, noting that TIPS, though there’s no associated cash flows, do have an inflation adjustment and tend to have longer durations in some circumstances.
Others agree that it’s time to avoid or dump long bonds. “If the bull market in bonds isn’t over, then you have to ask yourself if you feel lucky, or if you want to become a trader, because the risk level is too high to justify a ‘buy-and-hold’ approach,” said Michael Falk, a partner with Focus Consulting Group and chief strategist at Mauka Capital.
To the extent you cannot spend less in retirement, retire later or work some, his advice to retirees and would-be retirees would be to shorten the maturities of the bonds or bond funds in your portfolio. Consider also adding to the mix a type of annuity that provides a monthly income when you’re age 80+. “The annuity would help to protect against outliving your slower-growth/less-income producing portfolio,” Falk said.
Bonds still have a role in your portfolio
No matter whether the bull market in bonds is over or not, others insist that fixed-income securities still have role to play in your portfolio. “Interest rates have declined substantially over the past 30 years, and at today’s low levels, investors need to accept that the great returns they have generated in the past will not be earned in the future,” said John Nersesian, a managing director of wealth management services at Nuveen Investments. “However, we believe bonds still play an important role in building a diversified portfolio for most investors. An allocation to bonds, by definition, is money that is not allocated to stocks.”
What’s more, Nersesian said bonds tend to do well during periods of equity weakness. So, an allocation to this asset class offers a significant benefit—that being a reduction in volatility. And reducing volatility is important for two reasons. “One, volatility during retirement forces the investor to liquidate more assets at depressed prices which increases the risk of failure,” Nersesian said. “Additionally, volatility causes emotional stress for the investor which can often lead to poor decision making.”
Remember, he said, it’s not the average rate of return that determines investor success. “It’s how the return is achieved (sequence, volatility, and the like),” he said.
The days of simply investing 60% in stocks and 40% in plain-vanilla bonds, however, may no longer be sufficient for investors. “Investors need to think creatively in today’s interest-rate world,” said Nersesian. “Diversifying your sources of income can provide some advantages.”
Nersesian noted, for instance, that there are some interesting opportunities in high yield, foreign debt, preferred securities and municipal issues that allow investors to participate in fixed-income markets.
Others are taking a similar tack. Pavese, for instance, said that most of his firm’s fixed-income exposure is concentrated in more nontraditional segments of the market, such as mortgages. “These securities have had a tremendous run since forced selling punished prices in 2011, and the trade is in later innings today, but historically, late innings have seen the biggest gains in asset prices,” Pavese said. “Particularly, as we see more institutional money flowing into this segment of the bond market. Rising demand plus shrinking supply equals higher prices.”
Time to re-evaluate definition of fixed income
Pavese also suggested that investors should re-evaluate their definition of ‘fixed’ income. “Bonds still play an important role in portfolios from a risk-reduction standpoint,” he said, agreeing with Nersesian. “We even bought some long-term Treasurys recently, to hedge equity risk, as 10-year yields backed up over 2%,” he said. “But ‘fixed’ income will present a big risk to retirement planning once the impact of global money printing shows up in higher inflation down the road. Consequently, high quality businesses that generate and distribute rising cash earnings to investors should play an increasingly important role in portfolios.”
See “Investing for Income” in this week’s Retirement Weekly subscription newsletter to read which companies, according to Pavese, could play an increasingly important role in your portfolio and why.
Rate rise a ways off?
To be fair, unlike Buffett and Fuss, Pavese doesn’t think the bull market in bonds is over. But he does think investors need to be more selective in security selection. “Massive buying of bonds and other assets by global central banks is likely to continue to distort the prices of all assets,” Pavese said. “Quantitative easing will be with us for a very long time. Just ask the Japanese. In this environment, yields will continue to drift lower.”
For his part, Nersesian cautioned against trying to time the market, against predicting when rates might rise. “It’s probably tempting for investors to ‘predict’ the end of the bull market in bonds and the rise in rates,” he said. “Many investors have made this call over the past three years, and rates have remained stubbornly low.”
Diversifying and managing duration risk can help, Nersesian said, noting that a rise in interest rates can be a long-term positive for investors. “It allows for the saver to reinvest maturing funds at higher levels over time,” he said.
Robert Powell is editor of Retirement Weekly, published by MarketWatch. Learn more about Retirement Weekly here. Follow his tweets at RJPIII. Got questions about retirement? Get answers. Email rpowell@marketwatch.com.
Robert Powell is a MarketWatch Retirement columnist. He has been a journalist covering personal finance issues for more than 20 years. Follow him on Twitter @RJPIII.
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Article from http://www.marketwatch.com/story/