Find Bond Income In a Dicey Market

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.

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.

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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.

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A “barbell” strategy, which combines short- and long-term bonds while avoiding intermediate maturities, can also help shorten your portfolio’s duration. Rosenberg suggests a barbell with roughly 80% of assets in bonds maturing in less than two years and about 20% in longer-term municipal bonds or Treasury inflation-protected securities. Avoid traditional longer-term Treasuries, which are the least attractive area of the bond market now, says Michael Turgel, co-manager of the Eaton Vance Bond Fund.

Why own any long-term bonds right now? The reason goes back to bonds’ basic role in your portfolio: diversification. The longer-term bonds are more likely to deliver decent returns if stocks tank, Rosenberg says.

Create a retirement paycheck. New products are making it easier for do-it-yourself investors to construct bond “ladders”—another key strategy for combating rising rates. In a traditional ladder, investors might buy individual bonds maturing in each of the next ten years. Because you hold the bonds to maturity, you get predictable cash flow and can ignore the price swings that come with interest-rate changes.

But it’s tough for small investors to get proper diversification when buying individual bonds. A better bet for do-it-yourself investors: new “defined maturity” bond mutual funds and exchange-traded funds, which invest primarily in bonds maturing in a single year and liquidate and return assets to investors at maturity. Funds in this category include the Guggenheim BulletShares Corporate Bond ETFs, with maturity dates ranging from 2014 to 2022; iSharesBond Corporate Term ETFs, maturing in 2016 through 2023; and Fidelity Municipal Income mutual funds, maturing in 2015 through 2023.

Asset Dedication, a San Francisco money-management firm, recently started using defined-maturity bond funds to build portfolios tailored to deliver the exact level of income needed to match an investor’s spending needs for a certain number of years. Typically, eight to ten years’ worth of retirement “paychecks” are built into the account, says Brent Burns, the firm’s president. Because investments are held to maturity, the account can include longer-term holdings without raising concerns about price swings, he says.

Collect tax-free income. With so many segments of the bond market looking pricey, municipal bonds issued by state and local governments remain a relatively bright spot.

“Munis were unfairly beaten up” late last year amid scary headlines about Detroit’s bankruptcy, says John Miller, co-head of fixed income at Nuveen Asset Management. Although they’ve rebounded this year, a dwindling supply coupled with increasing demand bolsters the case for munis. In the first quarter, supply of the bonds was down almost 30% from last year, and higher tax rates are whetting investors’ appetite for tax-free income.

What’s more, “by and large, states, cities and counties are in far better shape than they have been in years,” says Marilyn Cohen, chief executive officer of Envision Capital Management, in El Segundo, Cal.

Cohen and Miller both like bonds backed by revenues from “essential services,” such as water and sewer systems. Cohen also likes some bonds backed by major cities’ transit systems and airports, such as San Francisco Bay Area Rapid Transit bonds maturing in July 2022 with a 4.125% interest rate and 2.5% yield to maturity, and Los Angeles airport revenue bonds maturing in May 2022 with a 5.5% interest rate and 2.5% yield to maturity.

If you’d rather have a manager do the work for you, consider a fund that has proven adept at sidestepping riskier issuers. Fidelity Intermediate Municipal Income (FLTMX) lost only 1.5% in last year’s rough muni market, landing in its category’s top quartile.

Reduce high-yield risks. Income-hungry investors loading up on high-yield corporate “junk” bonds may be biting off more risk than they bargained for. In addition to exposing investors to companies with lower credit ratings, high-yield bonds are barely living up to their name these days. The gap between Treasury yields and junk-bond yields is only about one percentage point above 20-year lows, says Wells Fargo’s Rusnak.

Money managers say it’s time to take a conservative approach to junk bonds—but not abandon them altogether. Steve Huber, manager of the T. Rowe Price Strategic Income Fund, likes BB- and B-rated bonds—the higher-quality segment of the junk bond market. Although yields are relatively low right now, he says, “high yield tends to do well in a slow-growth environment” like the one investors face now.

Rusnak suggests investors trim junk-bond risks by dividing high-yield holdings among corporate, municipal and floating-rate bonds. Floating-rate bond funds typically invest in bank loans made to companies with subpar credit ratings. The funds have been among investors’ favorite defenses against rising rates because rates on the bank loans are adjusted in line with a benchmark short-term interest rate. Fidelity Floating Rate High Income Fund (FFRHX) has generally avoided the sector’s junkier fare and beaten more than 80% of its category rivals over the past ten years.

Although the average high-yield municipal fund gained roughly 9% in the first five months of this year, these holdings can still offer valuable diversification and attractive yields, advisers say. And while high-yield munis traditionally yield only about 75% of corporate junk-bond yields, they’re now yielding over 30% more, Rusnak says. T. Rowe Price Tax-Free High Yield (PRFHX) has a strong long-term track record and has tended to hold up well when the muni market swoons.

Stay flexible. Some advisers are nudging aside traditional core bond funds in favor of go-anywhere, “unconstrained” bond funds. These funds aren’t tethered to a benchmark and can seek out opportunities anywhere in the fixed-income market.

The private client group at Litman Gregory, an advisory firm with offices in Larkspur and Orinda, Cal., now recommends that clients with 60% stock/40% bond portfolios devote nearly 25% of assets to unconstrained and multisector bond funds, compared with 17% in traditional investment-grade bond funds.

These funds generally have a lot of leeway to shorten duration and delve into lower quality or foreign bonds, so “you’re really giving the manager the latitude to invest where they see opportunity,” says Meredith Shuey Etherington, senior investment adviser at Litman Gregory. The firm uses funds such as Osterweis Strategic Income (OSTIX), which has lately invested mostly in high-yield bonds and cash and has a duration of roughly two years, and Loomis Sayles Bond (LSBRX).

The flexibility afforded to managers of the Loomis Sayles fund allows them to seek out holdings that “disentangle us from the U.S. interest-rate cycle,” says Stokes, the portfolio’s co-manager. Lately the fund has been adding to local-currency emerging-markets debt, seeking to take advantage of currency fluctuations as well as bond returns.Indeed, many managers advise retirees to think globally, given the cloudy outlook for U.S. interest rates. “There is so much uncertainty. The Fed doesn’t even know what it wants to do,” says T. Rowe Price’s Huber, who is also finding opportunities in emerging markets. “So a greater level of diversification makes sense,” he says—across bond-market sectors and across the globe.