For a supposedly boring investment, bonds have shown their capricious side lately. The bond bull market, widely thought to be sputtering out last year, has roared on in 2014. This year’s rally has left even the most seasoned fixed-income investors scratching their heads—and older investors in a challenging spot.
See Also: What's Driving the Boom in Bonds
With so many bond sectors sporting lofty valuations, it’s getting tougher for retirees to find safe, dependable income. Still, there are strategies you can employ to generate decent income from your bonds without loading up on risk.
It was only six months ago that investors big and small thought the bond market’s path was certain. The economy was perking up, the Federal Reserve was on track to end its bond-buying program in late 2014, and attention was turning to when the central bank would start raising its short-term interest rate. The consensus view: Bond yields, which move in the opposite direction of prices, would rise. And bond investors, particularly those in more interest-rate-sensitive areas such as longer-term government bonds, would suffer losses.
Instead, the economy fizzled, and yields fell as bonds rallied. The ten-year Treasury yield, which stood at 3% at the end of 2013, dipped below 2.5% in late May. And long-term government bond funds, perceived as portfolio poison at the end of last year, delivered average gains of nearly 13% in the first five months of this year, far outpacing the 5% return of Standard & Poor’s 500-stock index.
If you’re feeling confounded by your bond holdings, you’re not alone. “This year caught almost everyone by surprise,” says Mary Ellen Stanek, chief investment officer of Baird Advisors, which manages several bond funds. “Very few investment forecasters called for a big rally in bonds in the first five months of the year.”
While the rally may have pleasantly surprised older investors, this is no time to be complacent about bond-market risks. Because so many segments of the bond market have soared, money managers say they’re having a tougher time finding decent investment ideas. Low yields offer little cushion against the price declines that will come when rates rise.
The Fed is expected to raise its target rate around the middle of next year—and the market will anticipate the move by beating down rate-sensitive bonds. “When that correction happens, it could happen dramatically and quickly,” says George Rusnak, managing director of global fixed income at Wells Fargo. This environment “favors swinging for singles and being conservative” with bond holdings, he says.
A conservative strategy makes particular sense for retirees drawing down their portfolios. If you have to sell bonds to meet expenses at a time when rates are rising, you may put a permanent dent in your portfolio. And if you stay focused on why you own bonds in the first place (think income and diversification), you’ll be less prone to chase recent bond returns into risky, overpriced fixed-income sectors—a move that even bond-fund managers are discouraging. “We’re hard-pressed in this environment to argue that bonds are a screaming value and you should buy them because they’ll outperform,” says Lon Erickson, manager of the Thornburg Limited Term Income Fund. Instead, he says, bonds are “the ballast” of your portfolio.
Indeed, many fixed-income managers are adopting a more defensive stance and stockpiling cash in their portfolios. The Loomis Sayles Bond Fund, for example, had roughly 16% of assets in cash and very short-term Treasuries at the end of April. “The opportunities are becoming fewer, and the markets have become much less liquid,” meaning it’s tough to sell bonds in a pinch, says Elaine Stokes, co-manager of the fund.
Here’s how to restore bonds to their rightful place as the most boring part of your portfolio.
Trim interest-rate risk. Many investors seeking shelter from rising rates have abandoned longer-term bond holdings in favor of short-term bonds. Unfortunately, guarding your portfolio against interest-rate increases isn’t quite so simple.
Investors concerned about rising rates should first understand their portfolio’s “duration,” a measure of interest-rate sensitivity. The higher the duration, the more exposed you are to rising rates. A portfolio with a duration of five years, for example, will see a price decline of about 5% if there’s a one percentage-point increase in rates. You can check the duration of your bond funds by entering the name or ticker symbol at Morningstar.com and clicking the “portfolio” tab.
“Maturity,” however, simply refers to the time period in which all principal and interest must be paid. Long-term bonds are vulnerable to rate increases because they have a lengthy stream of future income that doesn’t reflect the new, higher rates. But short-term bonds are no cure-all. They can be hit hard as the market reassesses the timing of the Fed’s next rate move—and because their yields are so low, investors could easily suffer losses.
Consider the market’s reaction when new Fed chair Janet Yellen suggested in mid March that the Fed could start raising rates roughly six months after the conclusion of its bond-buying program. That timetable was shorter than the market anticipated, and Treasuries maturing in five years or less sold off sharply.
Although investors should be reining in their portfolio’s duration, plowing money into short-term bonds is “probably the worst way to accomplish the goal,” says Jeffrey Rosenberg, BlackRock’s chief investment strategist for fixed income. Moving into short-term bonds now “puts your portfolio in the most vulnerable area of the yield curve,” which is bonds maturing in roughly two to five years, Rosenberg says.
You don’t need to dump short-term bond funds you already own—but you might consider other ways to shorten your portfolio’s overall duration. Rosenberg suggests that investors looking for short-term bond holdings today think ultra-short-term—bonds maturing in two years or less. Although money-management firms have rushed out a slew of new ultra-short-term bond funds lately, check the price tag: Fees can eat up much of the paltry returns in this category, where the average fund yields roughly 0.7%, according to investment-research firm Morningstar. The new SPDR SSgA Ultra Short Term Bond ETF (symbol ULST) charges 0.2%, compared with 0.35% for the Pimco Enhanced Short Maturity ETF (MINT). Older investors may also want to consider bank products such as high-yield savings accounts, which yield as much as 1% or so and come with federal deposit insurance.