It should be no surprise to anyone that bond investors, on the whole, have experienced significant capital appreciation in recent years. The rise in unrealized capital gains may have caused the bond allocation in your portfolio to reach levels greater than you had planned for. Therefore, within the framework of asset allocation, it wouldn't be unexpected for a financial advisor to recommend rebalancing your portfolio to keep the allocations between different assets in line with your goals.
In his recent article, "The outlook for bonds: Are the good times about to end?" Vanguard's chief economist, Joe Davis, states, "If you're comfortable with your current allocation to bonds…you might be well advised to do nothing at all. But if the bond market's recent run has caused your bond allocation to surge beyond your preferred target, it may be a good time to rebalance back toward equities."
I'm tempted to address the fact that Davis seems to imply that a diversified portfolio only falls within a stocks and bonds framework, rather than including other assets, such as gold, real estate, or even peer-to-peer lending. However, his statement reminded me of something else I'd like to address: the fact that investors are often nudged in the direction of reallocating their portfolios simply because of price appreciation, without adequate consideration as to why they own certain assets.
For example, if you own a number of individual bonds strictly for the income and not for the purpose of capturing capital appreciation, should you really sell some of those bonds and allocate the money elsewhere simply because the bond is trading well over par? Or, if you are an investor willing and able to hold bonds to maturity, should you ignore the unrealized price appreciation and instead mark the bonds to their face value (100 cents on the dollar)?
In today's interest rate environment, would you give up a 5.60% coupon, long-term International Business Machines (IBM) bond you purchased at par (CUSIP 459200GS4), simply because the bond is now bidding around 136? Is it worth collecting six to seven years' worth of interest in the form of a capital gain and giving up the remaining 20 years of a 5.60% coupon? For the long-term bond investor more concerned with income than with the mark-to-market value of the bond allocation in his or her portfolio, this might not make sense. Yet, financial industry pundits marking the bond to market, rather than to maturity, might urge you to do so in order to keep your asset allocation constant.
To further examine what I am talking about, let's say an investor acquired the bonds in the table below, at par, over a number of years. Today, the bond allocation in that investor's portfolio now exceeds the allocation's original target range by several percentage points. The rise in the bond allocation was due to mark-to-market accounting.
Here's a look at the individual bond holdings purchased at par in this hypothetical portfolio:
Ball Corp. (BLL)
International Business Machines (IBM)
Peabody Energy (BTU)
Procter & Gamble (PG)
United Technologies (UTX)
Wells Fargo (WFC)
U.S. Treasury Bond
U.S. Treasury Note
This portfolio of individual bonds is full of unrealized capital appreciation. But the question an investor who holds this type of bond portfolio should ask is, "should I care?" If your bond allocation is meant to provide income with relative safety to the principal over long periods of time, is it worth giving up, say PepsiCo's (PEP) 5.50% coupon bond maturing 1/15/2040, even if you can collect a bit more than six years worth of interest right now? How certain are you that you will find another security that will provide you with 5.50% yields and the same level of credit and principal protection that PepsiCo's aforementioned bond could over time?
How about Procter & Gamble's (PG) 5.55% coupon bond, maturing a little less than 25 years from now? Procter & Gamble's stock is known as a dividend growth stock. Perhaps you should sell the bond, collect the close to seven years of interest up front in the form of a capital gain, and buy the stock instead? From an income perspective, this may be a smart thing to do if P&G can continue to grow its dividend at a sufficient clip over time. From a principal protection point of view, you have to consider whether moving down the capital structure for the chance to collect more income in the future is worth it.
Regarding the 3.75% coupon Treasury note maturing 11/15/2018, I can certainly make a strong case for selling that security at today's price. However, I would be making that case from the perspective of an individual security being overvalued relative to what I can find elsewhere in the financial markets. In other words, if I can collect approximately 4.75 years worth of interest right now in the form of a capital gain, I would consider selling my 6.25 year note and trust that I can make up the difference very easily over the next 6.25 years.
In fact, there are certificates of deposit (CDs) that could more than plug the hole. Two examples include the following: Goldman Sachs Bank's (GS) 7/25/2017 maturing, 1.80% coupon non-callable CD, currently offered at a discount to par on the secondary market (CUSIP 38143AXL4) and GE Capital Bank's (GE) 6/29/2017 maturing, 1.80% coupon, non-callable CD, currently offered at a discount to par on the secondary market (CUSIP 36160WN39).
With that said, while I would argue selling that note on the basis of the security being overvalued, relative to what else you can find, I would not consider selling the security simply because the bond portion of my portfolio outgrew, on a mark-to-market basis, the original allocation framework in which I intended my portfolio to remain. There must be other reasons -- besides the fact that mark-to-market accounting has changed your real-time asset allocation -- to sell an individual bond, especially in this interest rate environment.
If you are an investor with outsized unrealized gains in your bond allocation who has been told to reallocate your fixed income holdings into other assets, first consider the following:
1. If you own individual bonds for income and for safety to the nominal value of your principal, and you originally bought the bonds with the intention of holding them to maturity, why are you marking-to-market for the purposes of asset allocation?
2. If you bought bonds for capital appreciation purposes (i.e., for a trade), then follow your price targets and technical analysis; worry less about the shorter-term, real-time asset allocation in your portfolio. After all, it's only a trade. Soon you'll be reallocating the funds anyway.
3. If you own bond funds that are not defined-maturity funds, you should ask yourself whether the position is meant to serve as an ongoing income stream from which the principal is quite unlikely to ever be touched, or whether the principal will be accessed at some point in the future. If you plan to access the principal in the future, then marking-to-market and potentially reallocating your assets is worth considering when bond positions have appreciated greatly on an unrealized basis.
4. If you own bonds for the income, whether through individual bonds or bond funds, and are willing to move down the credit risk scale, you could consider reallocating your bond position by selling a higher amount of lower yielding bonds and buying a smaller amount of higher yielding bonds. This would lower your bond allocation while keeping the income the same. Although, it would increase the credit risk to the portfolio.
For example, let's say you own $30,000 of LQD, the well-known investment grade corporate bond ETF. It currently has a 30-day SEC yield of 3.08%. At this time, HYG, a well-known high-yield corporate bond ETF, has a 30-day SEC yield of 6.16%. A $30,000 position in LQD, based on the current 30-day SEC yield, would bring in $924 per year. In order to bring in $924 of income from HYG, it would only require a position of $15,000 at today's 30-day SEC yield. If you are willing to move down the credit scale into junk bond territory, you could rebalance your bond allocation without giving up income and without moving into other asset classes.
5. If you are considering reallocating money from bonds into stocks, keep in mind that you should not do so without spending some serious time thinking about equity valuations. Do not simply jump in because stocks are "cheap on an historical basis." That is something investors hear all too often nowadays. Instead, spend some time thinking through what type of valuations the market deserves and is likely to receive in the coming years given the realities of the post-financial crisis world we live in. This is a world that is quite different from the times during which stock markets enjoyed their historically higher valuations than we have today.
In closing, just because asset allocation enthusiasts may tell you to lower the fixed income side of your portfolio doesn't mean you necessarily should. There are many factors to consider before deciding to reallocate the bond side of your portfolio. You need to reevaluate why it is you purchased a particular position, what you hope to get out of it, and whether rolling the funds into something else makes sense from an income and valuation perspective.