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Historically low interest rates and what they portend for long-term bond buyers are causing institutional investors to rethink their classic allocation strategies. The traditional split of pension, endowment and other portfolios into two main “core” allocations of, for example, 65% equities and 35% bonds, is being questioned now that rates on investment grade bonds are so low that they promise, at best, only negligible returns, and – more likely – negative ones. As one market observer put it recently: “If there were a Hippocratic Oath for portfolio managers, then the ‘do no harm’ admonition would likely prevent you from buying any bonds at all.”

Drastic as such a negative judgment may seem, the reality supports it. Investment grade corporate bonds are yielding 3-5%, depending on credit and maturity. Government bonds, of course are yielding even less, in the 2 to 3% range. With rates at all time lows, the upside on such bonds is virtually nil, but the downside in terms of both credit risk and the risk of rising interest rates and inflation is enormous. So how could adding such bonds to a portfolio increase risk-adjusted returns? In a word, it can’t. All it can do is potentially drag down returns over the long-term.

Why bet interest rates will drop with rates already at record lows?

Traditionally, adding bonds – which combine an interest rate bet with a credit bet in the same instrument – was thought of as a way of increasing stability in a portfolio, by replacing some of the volatility of equities with the stability of bonds. But bonds – with their built-in bet that rates will either remain the same or go down – can only really offer that promise of stability if you buy them at an “interest-rate neutral” point in the cycle, where your chance of winning your interest rate bet is as great as losing it. In other words, buying bonds at a time when rates are historically high makes sense, since there is a good chance rates will drop, giving you the option of either (1) selling your bonds and making a capital gain, or (2) holding them and collecting an above-market rate until maturity. But buying bonds when rates are low offers you the likely opposite of those two results, either (1) having rates rise and you suffer a capital loss, or (2) being stuck with a below-market return until maturity.

Although changing long-established habits in the institutional investing world is like trying to turn course in a battleship, pension and endowment managers and the consultants who advise them are beginning to get the message. It is beginning to dawn on them that long-term bonds are NOT the only fixed-income investment option. Even more specifically, institutional investors are coming to appreciate that you can invest in credit without having to take an interest rate bet along with it. When you buy a government bond about 100% of your investment is an interest rate bet. When you buy investment grade corporate bonds, over 2/3rds of your coupon return is a premium for taking the interest rate bet, with only a small fraction being compensation for taking credit risk.

But when you buy high yield (i.e. non-investment grade) bonds, over 80% of your return is payment for taking credit risk; and when you buy floating-rate corporate debt, like loans, the entire coupon – 100% - is payment for taking credit risk. So if you invest in high yield bonds, of your current coupon of about 8%, almost 7% of it represents payment for taking credit risk. If you invest in floating rate corporate loans, your current instrument yield of about 7.5% is all comprised of payment for credit risk, with no interest rate bet at all. In fact when rates go up you will benefit, since the floating base rate (i.e. 3-month LIBOR) will rise with interest rates generally.

Retail investment opportunities

Of course, you don’t have to be a pension fund or large institutional investor to take advantage of this trend. Indeed, most of us individual investors can be far more nimble about changing investment course than our institutional investing brethren. If you want to avoid hitching your star to a losing strategy of betting on falling interest rates at a time when rates are already at all time lows, here are some suggestions:

  1. First of all, avoid classic “balanced” mutual funds that put a pre-set percentage of their assets in stocks and bonds. (Examples, Vanguard Wellesley and Wellington funds or any fund with “balanced” in its name.) In these funds the bond portion, which acted like a stable source of steady earnings in past cycles, can only be a drag in the medium to longer term.
  2. Construct your own do-it-yourself “balanced” fund, by pairing investments in blue-chip dividend paying equity-only funds with high yield bond funds or ETFs (like JNK or HYG, currently yielding close to 8%), or loan funds (like EFT, BSL, PPR).

It breaks my heart to discourage investment in the Vanguard Wellesley and Wellington funds, and other balanced funds, because these have been so good to investors during long periods of stable or falling interest rates. But now is not the time to be buying these funds.

By following this approach, you can create portfolios that will yield 5-6%, and still have some opportunity to grow, without having any elements in it that are likely to take a plunge when and if interest rates start to climb. In this "new normal" investing environment, such an approach should make many investors happy, and allow them to sleep at night as well.

Additional Disclosure: I am a freelance writer and occasionally am paid to write articles about the fixed income market, including high yield and loan investments.

Source: Investment Grade Bonds: Dinosaur Of Investments?