“The market’s not a very accommodating machine; it won’t provide high returns just because you need them.” – Peter Bernstein
If you missed the first four parts of my series on bond investing be sure to check them out:
BOND INDEX FUNDS
A simple approach to invest in a broadly diversified bond fund is to use a total bond market index fund. This offers you a low-cost solution to gain wide access to the different bond sectors.
The Charles Schwab U.S. Aggregate Bond ETF (ticker SCHZ) and Vanguard Total Bond Market ETF (ticker BND) are two examples. Vanguard also recently rolled out the Vanguard Total International Bond ETF (ticker BNDX) so you can access bond investments from around the globe to further diversify.
One weakness of the bond index funds and ETFs is the fact that they are heavily weighted in U.S. Treasuries and other government agency bonds, which currently offer relatively low yields. John Bogle, founder of Vanguard, brought up this point in a recent interview with Morningstar:
“There is just no doubt about what the underpinning is, and that is the Barclays Capital U.S. Aggregate Bond Index is very heavily weighted around 70% in U.S. Treasuries and U.S. agencies, government instruments, if you will. And that 70% is working at a very low yield, and the other 30% probably much more resembles what the average bond fund is doing out there, the intermediate-term bond fund, which is the appropriate maturity.”
Because of this fact it will probably be necessary to diversify even further than index funds when investing in bonds of you would like to increase your interest rate.
One way to gain more exposure to corporate bonds and other non-government bonds is through an actively managed bond fund.
The majority of the time it makes sense for individual investors to invest in index funds as opposed to active mutual funds (this is especially true for stock funds). But with rates at such historic lows the outlook for bonds is uncertain, at best (although I guess it always is).
For this reason I think it makes sense to have a seasoned fixed income portfolio manager that can be proactive and navigate the murky interest rate world that we live in.
Bill Gross of PIMCO and Jeffery Gundlach of DoubleLine are two of the smartest bond fund managers alive right now. They both foresaw the crash in 2007-08 and played the recovery correctly as well.
Felix Salmon of Reuters makes a strong case for investing in the today’s challenging interest rate environment with a seasoned bond pro:
“And to make matters even harder, there will certainly be a select group of bond investors out there which makes the right decisions rather than the wrong ones, and which manages to make good returns even in a rising interest-rate environment. It’s not easy, but it can be done. The problem, of course, is that it’s impossible to know ex ante who’s going to be the new bond star. My gut feeling is that it’s going to be someone who remembers 1994, the last time that we had a bear market in bonds.”
These guys aren’t perfect so there will definitely be periods of underperformance, but they have the experience and expertise to succeed.
The PIMCO Total Return Fund (ticker BOND) and DoubleLine Total Return Fund (ticker DBLTX) have both performed pretty well over both long and short-term investment cycles (Gundlach was previously with TCW Capital before going out on his own with DoubleLine). They are called total return funds because they seek to make gains through both income and capital appreciation.
I think a balanced approach between broad bond index funds and great bond fund manager is a good way to cover different possibilities for the unknown interest rate environment ahead.
If you would like to go a step further you can also use different bond fund structures to change the composition of your bond portfolio. Interest rates play large role in determining you bond returns over the long-term.
With interest rates currently at very low levels many investors are trying to determine how to invest in this type of environment when rates are rising as they have been the past few months. Bond investors refer to this as interest rate risk.
Here are some interest rate strategies to consider that could potentially reduce your interest rate risk:
(1) Laddered Approach: Laddering your bond investments means that you spread them out over different maturities to diversify your interest rates. With individual bonds you could invest in 1, 3, 5, 7, and 10 year bonds and as they mature continue to purchase new bonds.
This spreads your cash flows and maturities to decrease your interest rate risk and gives you more liquidity options as certain bonds come due.
With bond funds you could invest in a mix of funds with different maturities as well. Here’s an example:
- iShares 1-3 Year Treasury ETF (ticker SHY)
- iShares 3-7 Year Treasury ETF (ticker IEI)
- iShares 7-10 Year Treasury ETF (ticker IEF)
You could invest an equal amount in each fund to minimize your rate risk. A similar strategy could be created with any short, intermediate or long maturity bond funds.
(2) Barbell Approach: A barbell strategy involves investing only in short (1-3 years) and long dated (20+ years) bonds but not intermediate term bonds (3-10 years). This gives you the benefit of higher rates at the long end and the ability to pick up more yield on the short end if/when rates rise.
Just remember that long dated bonds carry much higher risk of larger losses to compensate you for the higher rate of interest so as rates increase the longer dated bonds will not fare as well.
You could also have a variation of this approach by investing part of your bond funds in safer, lower yielding bonds like treasuries and another part in higher yielding, riskier bonds like emerging markets or high yield.
I covered this before, but a new type of bond fund is being rolled out that gives you the option to invest in target maturity date funds. If you have specific time horizons for your investments or goals these types of funds can offer you features of individual bonds at a low cost while also diversifying your holdings.
Make sure you hold your bond funds in tax advantaged accounts (IRAs, 401(k)s, etc.) if at all possible because of the fact that they make interest payments on a periodic basis that are subject to taxes. Certain bonds like TIPS can be a tax nightmare so holding them in a taxable account will only make it harder for you around tax time.
The one exception in this case is municipal bonds which should only be held in taxable accounts because you get tax breaks at the federal and sometimes state and local levels. For this reason it makes no sense to hold munies in your tax advantaged accounts.
I wish I could give you the perfect investment strategy to thread the needle and play interest rates and bonds perfectly.
I wish I could tell you to invest 100% of your portfolio in stocks (and maybe some of you can) and just forget about bonds. But if you need to draw money from your investments within 5 years or less or you can’t handle large periodic stock losses you will need to include some bonds (or cash) in your portfolio.
Since no one knows what the future will hold it probably makes sense to take a balanced approach to your bond portfolio. This means diversification by geography and strategy.
Including total bond market index funds in both the U.S. and international bond markets will give you a low-cost, broadly diversified approach to a wide range of bonds. A total return fund should help you navigate the uncertain interest rate environment by taking advantage of opportunities in the bond market and more exposure to corporate bonds. TIPS will cover you in the case of rising inflation. Emerging market bonds can give you more income with a higher level of risk.
And then you can decide if using a laddered, barbell or goal specific approach makes sense for a portion of your portfolio based on your circumstances.
As with all investments make sure you choose target weights for your overall bond allocation and to each specific strategy you employ. That way you can rebalance to stay in line with your risk tolerance.
We’ve enjoyed thirty plus years of declining interest rates which has made life fairly easy for the bond investor. You could basically buy your bond index fund and sit back and enjoy the ride. The current state of interest rates will make the future of investing in bonds much more challenging.
In the final post in my common sense bond investing series I will go more in depth on the topic on everyone’s mind these days when it comes to bonds – rising interest rates. We will look at historical rates for some perspective on today’s rates and see how bonds have performed in rising rate environments in the past.