4 Tips on How to Build a Better Bond Position

It’s not easy being a bond investor. The struggle is real. Yields are low. Returns are flat. Meanwhile the S&P 500 stock market index rose nearly 27% in 2021 (Source: Morninstar.com). Bonds are like the quiet wallflower at the holiday party, overshadowed by the life of the party, the stock market. However, bonds can still have a place in your portfolio for many reasons, including diversifying away from stocks and providing interest income.

In other words, if you plan on sticking with bonds, here’s my advice on what to do.

1. Build a core bond position with bond index funds or ETFs.

I like to use several bond index exchange-traded funds as a core holding. I may use an inflation protected securities fund, an intermediate-term bond fund, and a short-term bond fund as my core fixed income position. Higher-income investors can use municipal bond index funds to generate federal tax-free interest (though municipal bond interest may still be subject to state and local taxation and the alternative minimum tax).

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I like using bond index ETFs for two reasons.

• Index ETFs are generally lower in cost than actively managed funds. Keeping costs down is crucial in a low-yield world.
• Bond index funds also provide instant diversification. Different types of bonds behave differently – some bonds are more interest rate sensitive – so diversification is important.

2. Add active management where it makes sense.

I like to blend active with passive. An active fixed income manager is more tactical and nimbler than an index. Active managers are more expensive, but they can take advantage of opportunities in the fixed income market, buying shorter- or longer-term bonds depending on interest rates, or go to cash to protect principal.

I use active fixed income managers as a “satellite” or tilt to my core bond position, usually 5%-10% of the overall bond allocation.

3. Consider buying from the private market.

Not all bonds trade on the public exchanges. Some companies prefer to go directly to a lender in a private deal. The company may do this to speed up the deal or may prefer to have the loan remain confidential – public bond offerings are just that, public. Because private fixed income is quicker and confidential, lenders can command and pay a higher interest rate.

The private fixed income market is not suitable for all investors. There is less transparency, because private bonds are not rated, unlike public bonds, which can be rated “A” or “AAA” depending on the health and outlook of the bond. The biggest risk is illiquidity, as usually private fixed income has only monthly distributions. The fees are higher too, something to consider.

Still despite these drawbacks, having some portion of a fixed income portfolio not tied to the whims of the public market can make sense. I usually only recommend private fixed income for sophisticated investors.

4. Use an annuity for a portion of the bonds.

There are many types of annuities. Fixed annuities pay a guaranteed interest rate for a set number of years, such as the first three or five years. Your principal is also guaranteed not to decrease. These guarantees are backed by the insurance carrier. Fixed annuity rates are usually higher than CDs, though a CD is backed by FDIC insurance, while a fixed annuity is not. With any annuity you generally can’t use the money (without a penalty) till you turn 59½.

Another advantage of a fixed annuity is the interest accumulates tax deferred. Whereas the interest on CDs and bond mutual funds is all taxed as ordinary income in the year it’s earned. That’s an important distinction. In a low-yield world you can’t ignore taxes. I think most CD investors if they looked at their after-tax returns would be sorely disappointed. Eventually when you go to withdraw money from a fixed annuity a portion of it will be taxable, but at least you can accumulate the interest tax-deferred along the way.

Fixed annuities generally make sense for those who will always have some of their money in fixed income, want principal stability, tax-deferral and a higher interest rate than CDs. While fixed annuities have no explicit fees, consumers will want to shop around as annuity rates vary. I also suggest using a highly rated carrier since the return of principal guarantee is backed by the creditworthiness of the insurer. Investors should be aware of the penalties on fixed annuities if they must fully surrender the contract early, usually in the first five years. For a fixed annuity to make sense, I always make sure the investor has other money readily available for emergency purposes.

Final thoughts

Bonds can have a place in a portfolio for a variety of reasons. They pay more interest than cash and can help hold a portfolio up if the stock market crashes.

There are several ways to build a bond position. Start with a core of bond index mutual funds. Blend in active managers where it makes sense. For sophisticated investors, private bonds may be an alternative to the public bond market if that fits your risk tolerance. Finally, consider a fixed annuity for tax-deferral and principal stability.

So don’t give up on bonds, just build a better bond position. For more information, please email me at maloi@sfr1.com.