In her first article for the blog, Heather Brownlie talks about how investors can build a bond portfolio on the back of rising yields.
I still have a land line phone. I never use it, no one I know calls me on it, but every month I pay the bill, almost without thinking about it. Staying tethered to the service is simply a habit (one I'm determined to break as part of my year-end checklist).
A similar thing has been happening in the bond market. In the decade since the financial crisis, "lower for longer" has been the mantra for interest rates. Ten years is a long time, and in the interim, many bond investors have acquired the "muscle memory" of stretching for yield to meet their income goals. Now that the Fed is gradually raising its policy rate, however, it may be time for investors to break the habit of outsized credit and liquidity risks, and learn a new routine.
The low rate environment had a big impact on how portfolios were constructed over the last decade. Not only have intermediate bond managers tilted into high-yield, emerging markets and loans, but many investors also have strayed out of bonds altogether into dividend-paying stocks. As we can see in the chart, since 2008, the median intermediate-term bond fund (green line) has become increasingly correlated to the stock market. Correlations dropped sharply in 2014, but have been inching up again.
Why is this a problem? The reach for yield reduces the potential diversification benefits of owning bonds by increasing correlations to stocks. In other words, many of us likely have strayed from a primary purpose of owning bonds: offsetting the risk of stock volatility, something we've had no shortage of lately.
The good news is that we now have an opportunity to course-correct. And now, as you do a bit of year-end financial housekeeping, is a good time to revisit how you are sourcing yield and at what price.
Here are three simple things to consider:
(1) Consider short maturity bonds.
With a flat yield curve and relatively tight credit spreads today, you don't need to take on much interest rate risk or rely on higher-risk assets like stocks to generate income potential. High-quality ultrashort- and short-duration bonds are sitting in a sweet spot right now: they offer potentially attractive yields, and their short duration means they're less exposed to interest rate risk (duration).
(2) Rotate up in credit quality.
We haven't yet seen a material uptick in bond market volatility. As and when that may happen, though, we tend to see credit risk increase with it. Consider that the two-year Treasury currently yields nearly 3%, according to Bloomberg. Rotating into an ETF like the iShares 1-3 Year Treasury Bond ETF (NASDAQ:SHY) can be a low-cost way to up the overall credit profile of your portfolio. You might even be able to capture a tax loss, as market prices for investment-grade corporate bonds have declined somewhat. Another option to consider is the iShares Short Maturity Bond ETF (BATS:NEAR), with a mix of floating and fixed rate bonds and more than 65% in issuers rated at least single A.
(3) Keep more of what you earn.
Could you be paying over 20% of your yield in fees? Shocking, right? I had the unpleasant experience of seeing that the seven-day cash yield in my brokerage account was in a government fund charging 42 basis points in annual fees, or nearly 20% of its gross yield. In a similar vein, I recently heard a pitch for a four-star short duration fund charging nearly 70 basis points. It may have sounded like a compelling story, but not at 25% of my yield. This should go without saying, but over time price can materially impact performance.
It's a new era for interest rates and time for a rethink on building a portfolio for the outcomes you want. As "lower for longer" becomes yesterday's truth, it's time to cut the cord on old habits and develop new ones for your bonds.
 Credit quality ratings on underlying securities of the fund are received from S&P, Moody’s and Fitch and converted to the equivalent S&P major rating category. This breakdown is provided by BlackRock and takes the median rating of the three agencies when all three agencies rate a security the lower of the two ratings if only two agencies rate a security and one rating if that is all that is provided. Unrated securities do not necessarily indicate low quality. Below investment-grade is represented by a rating of BB and below. Ratings and portfolio credit quality may change over time. Allocations are subject to change.
This post originally appeared on the BlackRock Blog.