Are Bonds For Dummies?

by: Adam Aloisi

Plenty of investment commentary tells us that bonds are in a bubble, are overpriced, and are a bad buy. One SA writer who I have the utmost respect for recently went so far as to call bonds "dangerous," which I found somewhat questionable. But, I suppose danger is in the eye of the beholder, based on what one's perception is of how others are investing.

Maybe some of this is semantics-related. Some refer to all fixed-income products as bonds, while some refer to less-than-ten-year maturity issues as notes. Maybe commentators think anything over 10-year maturity is dangerous, which might be more plausible. My suspicion is most negative statements are referencing ALL bonds, which, in my view, is a disservice. It's like me saying, "all tech stocks stink," without ample explanation. Just like all investment products, some bonds are good, some are bad, and some may thoughtfully and strategically fit an investment plan for one person, while for another, they don't.

Risk, but not Danger

Given the low rate environment, I would agree with bond detractors that the risk profile is high, especially for long-term paper. Rates have little room to move on the downside and have plenty of space to run on the upside. Common sense would dictate that investors keep maturities toward the shorter end of the curve, unless they have some crystal ball indicating that rates will remain constant for the next 30 years. But, pundits and armchair quarterbacks have been predicting higher rates for years now, with nothing yet come to fruition. Will rates ultimately push higher? Probably, but trying to predict whether that happens in one year or a decade from now is something no one can do with any level of assuredness.

So while I agree that there's a high level of historical risk here, is there danger? Bonds, notes, bills are a contractual obligation - assuming tragedy does not strike the issuer during the repayment period, your capital is returned. Domestic default levels have been quite low the past two years, even in high-yield land. That doesn't sound too dangerous to me.

Yes, with bond rates at historical lows, short-term, high quality paper won't keep up with inflation, but for some, capital preservation is a more pressing goal than beating inflation. And for those looking for an alternative to puny cash yields that don't want to wade into volatile equity, short-term high-grade bonds offer an attractive place to get some basically risk-free yield.

Investors willing to take on a tad more risk can find much higher yields with near-term maturities. For example, today you could buy a Goldman Sachs (NYSE:GS) note, with an A- rating from S&P maturing Oct. '16 with a 3.9 yield to maturity. You could also take a bit more risk with BBB- rated Best Buy (NYSE:BBY) maturing Mar. '16 and earn a 4.8% yield. Are GS or BBY going out of business over the next 4+ years? I don't think so.


The bond market is a diverse entity. Corporates, tax-free munis, agencies, high-yield, treasuries, international and emerging markets; there is hardly a lack of choice. And when you can also pick your date of maturity, you have control over time risk. So, given the plethora of options, once again I wonder why so many are so hostile to the idea of bonds in a portfolio?

Equity Yield Competition

The low rate environment has seen many migrate, or totally abandon the relative safety of bonds, and move assets into comparatively attractive high-yield equity. This makes sense, since equity yield is in many cases higher than 10-15 year fixed-income offerings from the same issuer. But one must wonder if those that are engaging in wholesale reallocation understand clearly the potential pitfalls of doing so.

I'll admit that over the past two years, I've shifted some maturing bonds into equity-income issues. It's not a gigantic percentage, and I feel I'm increasing overall portfolio risk by doing so, but I think the move has been warranted and tactically prudent.

About eight months ago I recommended income investors take a look at Cincinnati Financial (NASDAQ:CINF), American Campus Communities (NYSE:ACC), and Carnival (NYSE:CCL). Since then CINF has returned better than 35%, ACC has returned about 18%, and CCL has been basically flat. I am still constructive on all three longer-term, but would not be an aggressive buyer of any of the three right now.

I am supportive of income investors who thoughtfully allocate monies from credit to equity markets. However, I'll reiterate that wholesale abandonment of fixed-income because of the low rate environment, seems imprudent and perhaps reckless for those with a low risk tolerance profile.

Higher Yield

Agreed, yields are historically unattractive for risk-free return, but for those willing to venture out a bit on the risk spectrum, value and higher yield can indeed be found. While I'm not generally a proponent of funds, I think investors can do well by utilizing ETFs and CEFs for exposure to high-yield, international, and emerging market income, especially those who cannot diversify or perform credit analysis adequately on their own. However, funds, even those with short maturity profiles, guarantee no return of capital and could prove disastrous in a higher-rate environment. Caveat emptor.

I have done well over the years with Alliance Bernstein's Global High Income Fund (NYSE:AWF), currently yielding above 8%, although this is a very small position for me that I would certainly not recommend for risk intolerant investors. HYG, a domestic high-yield composite index, yielding 7.5%, is another popular fund for high-yield investors, but again, not an investment for the faint of heart. You can read more about closed-end funds in a recent article of mine.

The Bottom Line

Bonds are a diverse investment instrument. Given the low interest rate environment, the risk/reward outlook, by and large, is not favorable. And one could argue that investors clueless as to what they are doing might be in danger playing in bond market. But are bonds for dummies? You'll have to decide that for yourself.

Disclosure: I am long ACC, CINF, CCL, AWF.

Additional disclosure: The above should not be considered individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.