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Even though this is a dividend investing blog, I am well aware that several readers have other things in their portfolios. For example, I’m sure many of you have a portion of your assets invested in fixed income. Bond holders have been put under more pressure than usual in 2013. After 4 years of high returns due to the continuous efforts of all countries to suppress interest rates, bonds were among the worst performers in 2013.

Why? Simply because bond rates are at their lowest and the only direction interest rates can go now is up. This is not good news if you hold bonds in your portfolio. I expect the bond universe to do something between -2% and +2% this year. And +2% is very optimistic …

If You Invest In Bonds – You Will Eat Your Socks This Year

It’s finance 101 and all investors should know this: when interest rates rise, bond values fall. I’m not going to go over the theory but just consider that if you buy a bond for $1,000 and you get $40 (4%) per year in interest payments, nobody will pay you $1,000 if similar bonds are now paying $50 per year.

Historically, when interest rates went up, interest paid by bonds was enough to cover most of the drop in value. For example, if your bond value drops by 3% but it pays 6%, you are still making 3%. The problem now is that bonds are paying 2-3% and are expected to drop by more than 4%. Did you know that if your bond fund has a duration of 6 years, it will drop by 6% upon an interest rate increase of only 1%? This is why you need to do something in 2014. Don’t worry, there are many solutions to your problem. Some of them are riskier than regular bonds. On the other hand, you are literally sitting on a ticking bomb if you just keep your bonds as is and wait. Here’s what you can do:

#1 Drop the Duration or Wait

As I just mentioned, the duration of your bond portfolio is a crucial indicator of your potential loss. The key is to keep duration as short as possible. Some short term bond funds can show a 2-3 year duration. This should be enough to finish the year with a flat return.

If you hold bonds in a brokerage account, you are pretty much stuck to keep them and wait until they mature. At maturity, the bond issuer (government or a company) will pay you back the original value and you won’t lose anything. In the meantime, you will also earn a lower interest rate than others who buy more recent bonds.

#2 Corporate Bonds

In 2013, one sub-asset class in the fixed income realm did ok. It was corporate bonds. The reason is quite simple; since the economy is doing well; it’s easier for companies to do business. They are less likely to default now and still pay a higher interest rate than government bonds. For these reasons, the interest rates paid on the bonds were enough to compensate for the drop in value. If you move a part of your government bonds to corporate bonds, you should reduce the impact on your portfolio.

#3 Floating Rate Bonds

Another solution is to buy floating rate bonds. This is a special class of bonds that increases their interest payouts when interest rates climb. It also decreases them if interest rates fall. Floating rates are not fabulously high interest bonds but they are better than nothing when you might protect the potential downside of an investment.

#4 Preferred Shares

Preferred shares are issued by companies and pay higher dividend rates than regular shares. Their value also evolves in a similar manner as bonds and do not follow the stock market. Since they are not as liquid as regular shares, it is often advised to buy them through an ETF or mutual fund. Yeah, I know, you like to be in control of your portfolio, but this is the price to pay to access quality preferred shares.

#5 Non-Traditional Bond Funds

Here again, I’m going into the evil Management Fees (MER) territory but this is for your own good. Over the past four years, bond managers were very well aware they will have to face a zero interest rate environment. This is why they have worked on different strategies to compensate for that. A traditional bond fund will hold a basket of bonds depending on its investing policy (from junk bonds to govt. bonds). The manager can only play with the duration (sell its longer maturity bond to buy short term bonds) and work its magic with the credit spread between different class of bonds (corporate bonds vs municipal bonds for example). However, in most cases, its fund will suffer greatly from an interest rate increase. Non-traditional bond funds will add other strategies to their portfolio. For example, here are a few things managers can do to make sure they generate a positive return:

#1 Create a zero duration or negative duration portfolio. With the help of futures and swaps, they can manoeuvre the duration so it is equal to zero (e.g. interest rates have no impact whatsoever) or even create a negative duration (e.g. bonds would gain value upon a rise in interest rates).

#2 Bond market making. Instead of buying and holding bonds for their coupons, a manager can decide to buy a new issue of bonds and sell them to third parties (brokers) with a commission. Therefore, this portfolio is very high in cash and only generates a commission profit from bond trading instead of receiving the classic coupons.

#3 International bond portfolio. North America is within a very low interest rate environment, but it doesn’t mean that this is the case across the world. This is why bigger firms can buy emerging market bonds for example. Since they have a better follow-up (they usually have offices in those countries), they are able to buy bonds with higher yield and reasonable risk.

#6 Annuities

If you are retired and you are looking more for a source of revenues than growth in your portfolio, converting a part of your holdings into an annuity may be a good idea. Sure, most people will tell you that you leave money on the table (there is a price for any financial product). However, you make sure that you secure your interest rate and that you will receive money on a monthly basis for the rest of your life. I believe the key is not to put all your money in such a product and to consider a fixed “classic” annuity where you write a check to buy the contract and then you get paid. No fluff, no options, just plain and simple cash every month.

The good thing about an annuity is that you never see the value fall. You can read more about annuities here.

#7 Real Assets

I strongly believe in the increase of real assets in one’s portfolio. Real assets are defined as infrastructure projects such as paid highways, bridges and pipelines. These projects are usually financed through long term bonds of 20, 25 or even 30 years. Therefore, you know in advance how much you will have to pay (cost of doing business) while you remain with full control of your revenues. Most people will have to take the highway or cross the bridge to go to work so they will pay to use it. This is an asset class that is not directly related to the stock market and can pay a steady return over time. Unfortunately, this is another investment product you will have to purchase through a fund or private wealth management firm.

#8 Dividend Investing Anyone?

I once wrote on this blog that a 100% dividend portfolio is a safe portfolio. I sincerely believe this. If you focus on dividend growers and not dividend yield, you will be able to build a solid portfolio with companies that won’t fall apart overnight. Plus, your dividend yield will pay more than interest rates and it is less taxed. Replacing a part of your bond portfolio with dividend stocks is not a bad idea but I would definitely pick the strongest companies. Look for stocks showing strong cash flow and healthy balance sheets.

What is your trick to compensate for low interest rates?

Tell me how you manage your portfolio during these challenging times for bond holders. Maybe other readers can get ideas from you too!

Source: 8 Solutions To Compensate For Low Interest Rate Bonds