Bond Values at Risk
Bonds, shares of bond ETFs and bond mutual funds are increasingly at risk of loss of principal. The reason for this is the coming rise in interest rates and the effect of interest rate risk on the value of bonds and bond funds. In addition, current bond yields are very low, the lowest in 30 years. They produce a limited amount of income.
This Article Provides Solutions for Investors
In order to protect their principal, bondholders can respond with an appropriate strategy before rising interest rates erode their holdings. In addition, alternate investments may be sought in order to meet income goals in the current low interest rate environment. This article briefly outlines the risks of holding bonds today and goes on to provide alternate investments. These include certain "uncommon" common stocks, Exchange Traded Funds and bank deposits. That is, this article deals with solutions. For a more complete description of the problem, including quantification of the effects of rising interest rates on different durations of bonds, please see my recent article, Your Bond Allocation For 2013, It's Time To Lower Your Risk.
Credit Risk, Interest Rate Risk
There are two risks involved in holding bonds: credit risk, the chance that principal will be lost because the creditor cannot pay back the money and interest rate risk, the chance that interest rates will rise, and current bonds will be proportionally devalued in the marketplace, as new bonds issued will pay higher interest rates. This is a new and unique threat for today's investor, a foreseeable calamity beyond experience and expectations of most investors. However, it is not an apocalyptic myth dreamed up by prophets of doom, it is a mathematical certainty, the result of a sea change in the direction of a long-term trend.
This threat arises because for the last 30 years, the secular trend of interest rates has been downward, part of a long cycle. There have been the usual ups and downs of any traded securities, but in general, interest rates have fallen, and are now near zero. Part of the reason for the extreme and persistent recent decline is the manipulation of interest rates by the Federal Reserve Bank. It strives to increase economic activity and decrease unemployment by keeping interest rates low.
Uncommonly Bond-Like Stocks
Bonds are debt instruments, the means by which government entities and corporations use to borrow large sums of money. The bond issuer's first obligation is to pay bondholders the interest owed them, usually in semiannual interest payments, and return the capital at the end of the bond's term. For corporations, this obligation has priority over payments to any holders of preferred or common stock.
Stock is a share of a corporation, and the shareholders are the owners of the company. They have the rights and privileges of owners in that they are entitled to vote on important matters governing the company. Importantly, they get to share in the profits of the corporation by getting paid dividends from the profits. As the company prospers, the value of the stock may rise. However, some stocks behave like bonds in many respects.
How Are Some Common Stocks Bond-Like?
The stocks of some very unexciting corporations plod away, year after year, never soaring to the heights of Apple (AAPL) and Google (GOOG), or falling from favor as fads and expectations change. These would include, as a class, utility stocks. Often known as "widows and orphans" investments, they very routinely send out quarterly dividend checks, increasing them a little from year to year. The sellers of consumer staples are nearly as dull on a day-to-day basis. These are the makers of soap, like Procter & Gamble (PG), the sellers of tissue paper such as Kimberly-Clark (KMB) and the makers of foodstuffs found in every kitchen, like Heinz (HNZ).
Faithful Dividend Payers
These stocks are bond-like in several measurable ways. First, they are companies that have been around for a while, in the cases of Coca-Cola (KO) and Colgate (CL) since the 19th century. They are usually big firms, with large economic moats, which protect their domination in the market. They have good credit, and because of that strength can be borrowers at the best rates. Important to us, many have paid dividends faithfully from 10 to over 25 years, while increasing those dividends every year.
One measurement stands out, and that quantifies the most bond-like characteristic they have, their lack of share price volatility. Yes, their prices go up and down, but not like the high tech firms. The measure of this up-and-down-ness is beta. If that is Greek to you, let me explain. The market, let us say the Standard & Poor's 500, goes up and down. Its volatility, the average volatility of the market, is assigned the value of 1.0. If a stock is more volatile than the market as a whole, it might have a beta of 1.60. If it is correspondingly less volatile, it could have a beta of 0.40. So, one of the key measurements we will screen for is low beta, let us say a beta 0.50 or lower, to find stocks only half as volatile as the market.
The other thing we want is payment of a large dividend on a regular basis. Let us say we set a minimum yield screen at 3.0%. Thus, our selection of dull and boring stocks will churn out money every quarter with the efficiency and sweetness that Willy Wonka's Chocolate Factory turns out Everlasting Gobstoppers.
This collection of stocks has an average beta of only 0.25, a quarter of that of the market. The yield is a respectable 3.75% percent, much like the quality bonds of yesteryear. Interestingly, this kind low beta portfolio often outperforms the market.
I have written twice about a low-beta portfolio I constructed some time ago. The last article is A High Income Low Risk Portfolio Six Months Results. Unlike the portfolio above where I was looking for the lowest beta possible, in the previous exercise I added a sector discipline to assure diversification.
This particular collection of bond-like stocks paid out great dividends in the past year while beating the indexes.
While I think that putting together a portfolio of common stocks is an enjoyable pursuit, and better addresses my goals than someone else's contrivance, there are those who prefer ETFs over individual stocks. Let us turn now to look at several of those alternatives.
Boring and Bond-like Stock ETFs
We noted above that the S&P 500 has an overall beta of 1.0. What would you have if you took all the high volatility stocks out of that index? You would have the Standard & Poor's Low Volatility index and its corresponding ETF. Look at the movement of this fund over a period of 2 years compared to the S&P 500, the red line.
An interesting thing is the S&P 500 with its beta of 1.0 has a yield of about 2%. Take away all the high and low flyers and you have a gentler ride, plus a yield of nearly 3%. That is amazing; less risk and more return. Do not tell the MPT people about this, they will prove to you that it is not true by using methodology much more sophisticated than a squiggly red line dancing over a blue mountain.
(click to enlarge)
Morningstar says, Low-volatility stocks tend to be big, boring, and dividend paying. H J Heinz Company is a classic example. Boom or bust, Heinz ketchup sells with clockwork regularity, insulating Heinz's earnings from the business cycle. Stocks like Heinz are as bond-like as they can get. Interestingly, in nearly every market studied, low-volatility stocks have outperformed high-volatility stocks, a finding at odds with many investors' notions of risk and return.
Sector ETF Picks
We noted above that one of the sectors which was overflowing with bond-like boring stocks is the Utility Sector; the income refuge of widows and orphans. There are a lot of choices here so I will just list several that I think are reasonable picks. In addition, the Consumer Staples Sector is another haven for boring bond-like companies. Here are some offerings from that sector too
Summary of Alternatives
If you are holding bonds or bond funds of intermediate or long duration, you are likely to get a haircut as interest rates rise over the next few years. If you are holding short-term bonds or bond funds, or short-term inflation protected securities, you are getting very little yield. However, holding short duration bonds is a strategy that will offer some protection of your capital. Holding any individual bond to maturity, be it short, intermediate or long-term, does not pose an interest rate risk. That is an advantage of a bond ladder or other individual bond strategy over a bond fund; the bond fund is always buying and selling to maintain its stated term.
An alternative to going to short durations for principal protection is to take part or all of the money from intermediate and long-term bond funds and move it into CDs. The rate is about 1% for a 1 year CDs and 1.5% for a 5 year CD. Like some short-term bonds, that could be a negative real return after inflation. However, for some people that is better than losing 10% or more as the value of bonds slides, or losing sleep over perceived riskier stock investments.
A best alternative for many investors is to reduce holdings in intermediate and long-term bond funds and invest in individual low beta stocks, such as the "Portfolio of Bond-Like Uncommon Stocks." The ETF S&P Low Volatility Fund (SPLV) offers another option and ETFs in the Utility Sector or Consumer Staples Sector should provide stability with good dividends and the promise of continuing dividend growth.
There are no sure things and few certain choices in investing. That is why a diversity of holdings is such a powerful risk alleviator. Interest rates could stay low for a much longer period than expected. This happened in Japan, which has endured a lackluster economy for two decades. That would mean no sharp bond cliff of interest rate increases, but continuing very low returns. Stocks have their own risks. One could move significant assets into stocks, only to have the stock market fall 20% in a correction. This, however, would probably not affect the flow of dividends.
Another consideration is where are you in your investing lifetime? Is accumulation of capital your primary objective? Is income to spend today the most important thing? Are you willing to take big risks for big gains? On the other hand, is your primary concern protecting a nest egg accumulated over a lifetime? Consider your choices carefully, listen to different opinions, do what is best for you. Sometimes that is doing nothing, sometimes is moving to a larger cash position, sometimes it may mean a shift in your asset allocation, in this case to a larger proportion of stocks.
Take care in all your endeavors. Good luck!