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Increasing Risk in Bonds

Investors are now exposed to sizable losses in investments typically heralded as safe. The value of bonds and shares of bond ETFs and bond mutual funds are increasingly at risk.

The objective of this article is twofold 1.) Enable the reader to set appropriate asset allocations to meet their investment goals in today's economic environment; 2.) Enable the reader to understand the bond term "duration" and make informed decisions to protect capital in an upcoming era of rising interest rates.

Strategic moves and specific action items can decrease your risk of loss significantly; this article presents these.

An Update for 2013

Last year I wrote an article entitled A Bond Allocation For Your Dividend Growth Portfolio. This is an update of that article for 2013. I have not duplicated the foundational material in the original article. It covered the definition of stocks and the definitions of bonds and bond terminology and the alternatives for fixed income investing. Please click on the above link to refresh your knowledge of the basics. In this article, I will describe the allocation of my assets and the holdings of my fixed income portfolio today.

I will review the meaning of the term "duration" as it applies to bonds, and speak on how important that measurement is to us today. Allow me to begin with the summary from the end of the previous article.

"Fixed-income holdings supplement a dividend growth portfolio to provide a dependable retirement income with stability and lowered risk of capital loss. As interest rates are expected to rise, you may wish to underweight bonds while keeping the durations short. A bond allocation is important, but dividend growth stocks remain the primary engine to power your retirement.

"Some advocate a current position of 100% stocks; others believe that a move to shorter durations or a flight from bonds based on rising interest rates is premature. Differences of opinion are healthy in investing; they provide an opportunity for clearer articulation of beliefs and stimulus for deeper analysis and reflection."

Asset Allocation

Last year I described the reasons for asset allocation, and related that mine was 65% stocks and 35% bonds. I mentioned that allocation of more stocks than bonds was the reverse of what a retired person might traditionally hold. Stocks traditionally have better growth performance over the long term, but bonds, on the other hand, are apt to vary relatively little in price, and pay out a large amount of interest income. That made them suitable for the retiree who is more concerned about income today than growth for tomorrow.

Interest rates fell. It did not happen all at once, but has been a bumpy trend over the past 30 years. Even as few as 3 or 4 years ago, one could get a 4% annual interest rate on a CD or a 10-year treasury note. That is true no more. One is lucky to get 0.95% for a one year CD or 1.5% on a 5-year CD. Bonds are reaching new low yields. They are no longer the haven of safety, stability and certain income they once were. They no longer add a gentle ride to a balanced portfolio by dampening the effect of corrections by their steadiness nor ameliorate them by an inverse correlation.

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Creditworthy corporations, exemplified by firms like Johnson & Johnson (NYSE:JNJ) and Microsoft (NASDAQ:MSFT) provide more income to stockholders with dividends than to those buying their bonds. In addition, for the top tier of dividend growth stocks, the dividend increases year after year, through good times and bad. This, of course, counters inflation in a way no fixed income investment can - not even Treasury Inflation Protected Securities (NYSEARCA:TIP). In fact, investing in those bonds can be dangerous to your financial health.

In Dangers Lurking in the Bond Market, David Templeton states,

Compared to the last 30 years, the next investment era may produce similar equity returns but far lower bond returns. Expect the added diversification provided by bonds to diminish substantially relative to the smoothing impact bonds have provided in the last 15 years. Finally, investors should prepare for a much steeper tradeoff between risk and reward. In the years ahead, additional risk will likely be more handsomely rewarded than has been the case in the last 30 years. Perhaps, most importantly, if the risk-return frontier is about to take on more of its pre-1981 character, investors need to question whether current conventional asset allocation parameters, born out of the culture of the last 30 years, are still appropriate?

My answer to that is "no." Following this argument to its logical conclusion one must ask, why buy or hold any bonds? Some would suggest that portfolios consisting of 100% equities best serve investors.

Forty-year veteran of the securities industry and highly respected Seeking Alpha author Chuck Carnevale is of that opinion. In a recent conversation, he said,

"Under a more normal interest rate environment, I am happy to include bonds for those seeking maximum income, and safety. Under more normal conditions, an appropriately laddered bond portfolio can be designed to handle future rate changes, without long term, or permanent damage to the portfolio. However, these are not normal times, and today I eschew bonds completely. Primarily because common sense dictates that with rates approaching zero, the risk profile of bonds is aberrantly high.

Investors should realize that if rates rise, intermediate to long-term bonds will see price drops equal to any we have seen with equities. Moreover, the price drops can persist for a longer time (out to maturity) than it took stock prices to recover after the Great Recession."

Chuck went on to say, "Bonds typically should provide higher yield and safety than available from dividend paying equities. For the first time in my more than forty-year career, the reverse is currently true." I can attest to the fact that in my recollection as an investor for about the same period I have never seen anything like this. The two-fold problem, to reinforce what I said at the beginning of the article, is the paucity of income available from bonds and the risk of loss of principal. This has forced me to reassess my foundational training in securities investing. It pushes me out of my comfort zone.

2012 Fixed Income Holdings...35% of Total Retirement Portfolio

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2013 Fixed Income Holdings...17% of Total Retirement Portfolio

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My current asset allocation is 73% Equities, 17.3% Fixed Income and 9.7% cash. Of the 17.3% fixed income securities, Preferred Stocks account for 2% of the total. That is, I cut my bonds in half, from 35% to 17% of my total retirement portfolio. In addition, I have groomed my holdings to include bonds with shorter durations. The current numbers on TIPs are, SEC Yield 1.29, YTD Return -0.33 and duration of about 6. The duration for the VTIP is only 2.5.

My next move, within several months, will likely be to invest half of the cash on hand in equities, bringing my allocation to 78% stocks, 17% bonds and 5% cash.

I most likely will hold the individual International Paper BBB bonds and the Seagate, BB+ bonds to maturity. I will closely monitor my position in TEGBX. TEGBX is a Morningstar Gold 5 Star Global Bond Fund, and it has performed well. VCSH is what I consider it a "near cash" position, a potential backup to my rainy day fund in the case of an extraordinary emergency.

Duration

Duration is the most important thing you need to know about your bond portfolio in 2013. Duration is a measure of how sensitive the value of a bond is to changes in interest rates. A high number indicates that it is very sensitive to interest rate changes; a low number indicates that it is not. The unit of measure is years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. If interest rates rise 1%, a bond with duration of 5 years will decline 5% in value. If a bond has a duration of 2 years, if will lose 2% of its value.

As interest rates are near 0% now, they can only increase as economic conditions move back to normal. Interest rates in the 3% to 4% range are very usual. The graphic below illustrates the fall in bond prices as interest rates rise.

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The above graphic shows the impact of a 2% rise in interest rates on bond funds of different durations. Below, I have summarized the impact on three different interest rate changes on two of the bond funds I hold. The size of the numbers in red ink has my attention, and will move me to action.

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With a debt instrument issued by the US Government, there is little credit risk. With inflation protected securities, you are somewhat protected from the insidious erosion of buying power due to inflation. However, investors in TIPs and other types of bonds should be concerned about the effects of longer durations in an environment of rising interest rates. In general, in this low interest rate environment, since interest rates can only rise, in most cases it is best to hold bonds and bond funds with a shorter duration. The exception would be if you owned long-term bonds and knew you would never sell them - you just want the income.

It is also wise to understand the differences between holding individual bonds compared to bond funds. This article includes an appendix with a brief overview of the differences.

The below table, based primarily on data from Vanguard, summarizes the yield, year to date performance, 1 year performance and duration of corporate and government bonds of different terms.

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Actionable Alternatives

  • Rethink asset allocation and consider going to 75% - 80% stock, or even 100% stock, instead of holding 60% stocks and 40% bonds, or other traditional allocation. Eliminate the longer duration bond-fund holdings and longer duration bonds.
  • Move bond resources to similar instruments with shorter durations. From TIP to VTIP, from Intermediate Term Bond Funds to Short Term Bond Funds.
  • Consider bonds from emerging nations.
  • Consider taking short positions in bond funds.
  • Replace income-producing bonds with "bond-like equities." These would be steady and slowly growing dividend paying stocks with low betas and long and strong histories. Some examples from my watch list are Consolidated Edison (NYSE:ED), Northwest Natural Gas (NYSE:NWN), California Water (NYSE:CWT) and General Mills (NYSE:GIS).

Cautions

Bonds, at first glance, are seemingly simple instruments, which we expect to generate income benignly without giving us much cause for concern. If that ever was true, it is no longer true. Bonds and bond strategies can be very complex. If you cannot assess and reduce the risks in your portfolio on your own, seek the services of a financial planner, registered investment adviser or chartered financial analyst who can adjust or remake your portfolio to guard it against today's risks. If you are working with individual bonds, be warned, not every investment advisor has a high level of competence in that area. Sometimes the bond desk of a large brokerage may be helpful. Ask questions and seek out experience and expertise. Consider different points of view, and chose that which serves you best.

Take care always and good luck!

Appendix: Bond Funds are Not Bonds

Bond funds offer some advantages for the small investor. The first of these is convenience. An investor can take a position in a core bond ETF, get great diversification with one simple order for a relatively small amount of money. The professional management of a bond fund gets optimum pricing when buying and selling. Dividends are usually paid monthly, instead of just twice a year as is the case with bonds. It is an easy way to invest.

Other aspects of bond funds may work to your disadvantage. Funds usually maintain a constant duration, depending upon their charter it could be Short Term, of 2 to 3 years, or much longer in the case of a Long Term government fund. In a long-term fund, bonds are sold as they near maturity to keep the durations long. If you were to hold individual bonds, you could hold them until they mature, thus eliminating interest rate risk. Therefore, a disadvantage of bond funds is interest rate risk. In addition to an unpredictable income stream, fund buying and selling may involve taxable capital gains, distributed to you, causing unforeseen tax consequences.

Resources

Learn Bonds A site about bonds

Bond Tutorials Investopedia

Smart Bond Investing FINRA

The Author Suggests These Additional Seeking Alpha Articles

Bard Luippold Article, Fixed Income: Fewer Places To Hide?

David I. Templeton Article, Bonds Continue to Deliver Painful Results for Investors

Ploutos Article, How Risky are Bonds, Stocks?

Jon Parepoynt Article, Finra Sounds The Alarm For Bond Funds

Bud Conrad Article, The Coming Crash In The Bond Market

The Financial Lexicon Article, The Financial Lexicon Positions For 2013 Limited Bond Market Opportunities Mean Patience Is Key

Joseph Reinke Article, Your Long Term Risk Vs. Reward Investment For 2012

Tom Luongo Article, Stunning Bond Collapse Will be Gold's Gain

Source: Your Bond Allocation For 2013: It's Time To Lower Your Risk

Additional disclosure: I also hold VTIP and TEGBX.