Balancing Your Bond Investment Decisions

JGH-WW.jpg

 

December 13, 2012

 

Bonds can play an important role in your portfolio. But their role may vary according to your financial needs and concerns. For example, you may look to bonds for safety, income, and stability in your portfolio. You must weigh these priorities against your concerns over future interest rates, inflation, government debt, and other factors that might affect bond returns. 

 

Striking this balance can be a challenge in any market environment, but especially now, as low interest rates have sent many investors on a quest for higher-yield bonds or alternative investments. However, this pursuit of income can invite more risk.

 

So, what should you do? How can you make prudent bond decisions while also addressing today’s low interest rates? Consider these principles:

 

Remember How Markets Work

The same core investment principles apply in any market environment. One key principle is that in a well-functioning capital market, securities prices reflect all available information. Today’s bond values reflect everything the market knows about current economic conditions, growth expectations, inflation, Fed monetary policy, and the like. So, according to this principle, the possibility of rising interest rates is already factored into bond prices.

 

Rather than trying to predict macroeconomic forces that are difficult to foresee, you can look to the market to set prices and focus on the variables that are within your control.

 

Start with a Clearly Defined Goal

Bond choices should follow a broader investment strategy that defines the role of fixed income in a portfolio. The portfolio can then be customized to meet those specific goals while managing tradeoffs.

 

Understand the Tradeoffs

When reaching for higher yield, you should carefully consider the potential effects of your decisions on portfolio risk. In the bond arena, you have two primary ways to increase expected yield and returns on bonds. You can:

 

  • Extend the overall maturity of your bonds (take more “term risk”).
  • Hold bonds of lower credit quality (take more “credit risk”).

 

These may be reasonable actions. But pursuing higher income means accepting more risks, which express themselves as interest rate movements, price volatility, or greater odds of losing value if the issuer defaults.

 

Pay Attention to Costs

You might not realize that investment-related costs determine a large part of a portfolio’s yield and return. This applies especially to bond securities. In fact, research has shown that a bond mutual fund’s expense ratio helps explain much of its net performance. 1

 

Consider a Global Bond Strategy

You have other tools available to enhance risk and expected returns in bonds. You can expand your opportunities by moving beyond the U.S. bond market to access yield curves in other country markets. By owning bonds issued by governments and companies from around the world, you can enhance diversification in your bond portfolio.

 

Summary

No one really knows when and by how much interest rates will change. If you are looking for higher bond income, you should understand the higher risks tied to your decisions.

 

PARTNERSINWEALTH believes you would be best-served by following these strategies:

  • building a bond strategy to complement your broader portfolio objectives
  • understanding the sources of risk and expected return
  • paying attention to fees
  • looking beyond your own country to capture yields in other countries’ markets

 

Endnotes

Article originally written by Bryan Harris of Dimensional Fund Advisors

Investing risks include loss of principal and fluctuating value. Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors.

1. The study examined monthly alpha and expense ratios for bond funds in the CRSP survivorship-bias-free mutual fund database from January 1992 to December 2011. Source: Dimensional Fund Advisors.