Fellow LearnBonds contributor TheFinancialLexicon recently wrote a well thought out piece defending investment in long-term bonds despite the generally negative current perception of doing so. Bonds as a whole continue to receive a bad overall rap in my view, even though the theoretical capital risk of investing in them is tangibly low compared to equities, preferred stocks, real estate, and other assets with variable pricing and no guaranteed return of principal.
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But even as a bond proponent I have to admit that historically low interest rates make fixed income total return prospects somewhat negligible in the current market. Further, the opportunity costs of holding bonds, especially long-term bonds, in a rising rate climate will be high. Yet even these near-term detractions do not change the unique capital guarantee proposition afforded by individual bond issues held to maturity.
From my perspective there are several ways to think about investing in bonds and/or structuring an individual bond portfolio. If you know you will be committing funds periodically to the bond market over a stretch of years, or perhaps even decades, and don’t want to over think each investment, then I think a passive or “agnostic” interest rate and maturity approach is prudent. You acknowledge the opportunity risk of going long, especially now, but hedge that risk by committing to investing in more bonds at similar maturity points in the future, regardless of whether rates go down, up, or flatline. Over time this creates a passive bond ladder and decreases overall average weighted portfolio maturity while maximizing yield.
Others may be less inclined to be passive with their allocation and more inclined to be more hands on in an effort to build portfolio value. This means that with each purchase, one tactically evaluates the current fixed-income landscape and macroeconomic environment, perusing yields at different credit points and at different maturities with the goal of investing in the current “sweet spot” of the market from a risk/reward perspective. More active bond investors with more established portfolios may also look for near-term opportunities to lengthen or shorten overall weighted maturity or credit risk relative to events affecting the broader bond market or specific held issues.
Finally, there are investors who are less interested in building a portfolio predicated on income/capital preservation and are more interested in garnering capital gains. These would be investors looking for near-term profit opportunities from sudden market gyrations due to interest rate movements, macroeconomic events, or perhaps company specific developments. These types of investors may utilize leveraged vehicles or other aggressive methods to magnify their near-term prognostication by as much as three times normal market movement. Leveraged credit market timing is a risky proposition that should be attempted only by experienced investors or those with a very high risk tolerance.
The unusual economic environment that we live in today makes development and refinement of a strategy somewhat difficult in my view. Many investors may be inclined to avoid bonds altogether when they see equally attractive yields in the equity markets. One might also be scared off by fear mongers or omnipresent bond “bubble” commentary. As a proponent of asset diversification, I think it would be a mistake to avoid bonds. While tactically speaking, for some investors it might be wise to underweight fixed income relative to other asset classes, I think for the average investor bonds still have their place, perhaps more of a place than most really realize.
When I first started investing in individual issues 15 or so years ago, I was passive and conservative, but as I developed skill and more market awareness, I became much more active and more aggressive. I think that would be my advice today. Start slow and conservatively if you are unsure – buy A or better credit perhaps at intermediate maturities, build your knowledge and comfort and become as aggressive as your risk tolerance and credit acumen dictate going forward.
Building a portfolio of individual bonds may seem daunting, but like any other undertaking in life, a bit of trial and potentially some error, continued education, and a “practice makes perfect” attitude should ultimately get you on the right track.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.
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