Yes, There Is Still Hope In Bond Investments

by: MyPlanIQ

Current bond yields are at historical low. Even though Federal Reserve's quantitative easing is ongoing and at some point, it is going to tail off. The Fed Chief Ben Bernanke is likely to retire next year. In the meantime, investors are forced to invest in risky assets. The S&P 500 is making record highs daily.

So it seems that the 20 year bull market in bonds is near its end. It is hopeless for fixed income investors. But we don't believe this is the dead end for fixed income investing. There are still plenty of opportunities that can be explored.

First, as what was stated by Andrew Martin in his advisorperspectives article, "Interest rate increases have unfolded gradually; Since interest rate increases have been slow, rising interest income will outweigh the loss in principal value. " A fixed income bear market does not unfold overnight and there are many ways to adjust one's portfolios.

Second, even in a rising rate environment, there are several bond segments that can still present opportunities:

  • high yield bonds (HYG,JNK): with super loose and accommodative monetary policies from the central bank, companies can obtain credits more easily. Low grade companies such as those small cap companies can finance their operations through junk bond issuing. High yield (or junk) bonds have exhibited strong and reliable momentum, as shown by our advanced portfolios such as P High Yield Bond Alpha VWEHX. This renders high yield bond funds as good candidates for a trend following strategy.
  • Long term bonds in TIPs (inflation protected bonds, TIP, LTPZ, STIP, WIP), Treasury and corporate bonds (CSJ,VCSH,CIU,VCIT,CORP): long term bonds (LQD, VCLT,TLT) have played important roles in a permanent portfolio (see All Weather Portfolio Construction Part 1: Permanent Income Portfolio) or risk parity based all weather portfolio (see Ray Dalio's All Weather Portfolio: A Variation of Permanent Portfolio). Both Harry Browne and David Swensen have advocated using long term bonds as an insurance for a portfolio (see, for example, David Swensen Six ETF Asset Individual Investor Plan). Given exceptional low yields in the long term bonds, however, one has to be careful, especially in using them statically in a strategic asset allocation portfolio. We would feel more comfortable in using them in a tactical or trend following portfolio to take advantage of these bonds' strength when present.
  • International and emerging market bonds (EMB,PCY,BWX): two reasons to have these bonds as portfolio building candidates: 1). U.S. dollar weakness as the loose monetary policy adopted by the Federal Reserve bank and the U.S. government debt issue have driven U.S. dollar valuation steadily lower for the past 10 years. It is thus a good hedge to have exposure in foreign bonds that are denominated in local currencies. 2). The past decade has seen emerging market economies have risen to rival developed markets. In fact, many emerging market countries such as China, Brazil and Russia have sovereign debts that are much more sound (at least based on reported data). Emerging market debts have high yields. We again feel investing in these bonds warrants an active or tactical approach.
  • Floating rate bond funds (FLOT,FLTR,EFR) have short maturity and can latch on rising interest income.

Of course, all of the above bonds are sitting on the riskiest end of the fixed income risk spectrum. These assets are not going to rise forever, there will be up and down periods. In fact, at the moment, we see very little value in high yield and long term bonds. The key here is to capture these bond assets intermediate trends. Bond asset rotation can help. Diversification also helps: constructing a fixed income portfolio that has some limited exposures into these riskier bond assets is one way to hedge out risks among inflation, deflation and currency depreciation.

To take advantage of bond segments' strength in various periods, one can adopt a trend following strategy that acts upon an array of diversified bond ETFs. The following portfolio uses trend following strategy over a list of bond ETFs: JNK, LQD, TIP, MBB, TLT, SHY, IEI, BWX. It selects top two ranked ETFs every month to invest.

Portfolio Performance Comparison (as of 4/1/2013)

Ticker/Portfolio Name 1 Week
1Yr AR 1Yr Sharpe 3Yr AR 3Yr Sharpe 5Yr AR 5Yr Sharpe 10Yr AR 10Yr Sharpe
P Bond ETF Momentum Monthly 0.3% 0.9% 9.9% 1.78 8.8% 1.04 8.8% 1
PTTRX 0.2% 0.5% 8.0% 3.29 7.0% 2.07 7.8% 1.71 6.7% 130.2%
AGG 0.3% 0.1% 3.6% 1.45 5.3% 1.55 5.2% 0.77
BND 0.3% 0.0% 2.8% 1.04 5.0% 1.41 5.0% 0.86

*: NOT annualized

**YTD: Year to Date

(Click to enlarge)

The portfolio not only out performed the general bond index ETFs (BND, AGG), it also did better than the famed PIMCO Total Return Bond Fund (PTTRX, ETF equivalent BOND).

Investors can add more varieties of bond ETFs such as those mentioned above as candidate funds to construct a portfolio that is fortified for the coming bond bear market onslaught.

The take away from this article is that fixed income investors should be more vigilant and active. But they shouldn't be forced to chase yet another stock bubble to risk their hard earned capital.

Disclosure: I am long TLT, LQD, BOND. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.