Individual bonds bring many advantages to the table comparatively speaking: a guaranteed return of capital, a dependable stream of income, and control over maturity, credit quality, yield, and tax consequence. However, despite the benefits and flexibility inherent in owning them, the low interest rate environment has created relative bond yield deprivation, which, especially for risk sensitive investors, poses a dilemma.
To see a list of high yielding CDs go here.
Indeed the robust, “risk-free” yields once found in savings accounts and CDs, and attractive “safe” bond yields found in high grade corporates, AAA municipals, and treasuries, continue to be a thing of the past. Investors looking to reinvest longer-term bonds and CDs that have recently matured are in for a bit of sticker shock.
Thus, somewhat difficult choices may need to be made to maintain an income stream. This might include increasing maturity to uncomfortable levels, upping exposure to lower grade corporate or municipal credit, or considering alternative investments, including equities. For some, there may be prudence in looking beyond bonds, but careful consideration of risk and thorough self introspection should be conducted prior to either allocating away from or totally abandoning a bond strategy.
Many detractors argue that bonds are in a “bubble.” They contend that since rates have little room to move lower and plenty of space to move higher, that buying bonds at current pricing and yield constitutes a monumental mistake. I would agree that locking an entire portfolio into long-term paper or junk debt right now may not be particularly wise, however, cynics that cry “bubble” on all bonds are using a very wide brush to paint their canvas when they should be using something substantially more narrow.
Some of these critics advise that bonds be avoided in favor of cash-flow equity cows like utilities and Real Estate Investment Trusts (REITs), and dividend growth stocks, which they consider substitutes for the anemic yields in investment grade bonds. First, let’s agree that for many income investors, a diversified group of stocks may have their place as part of an investment portfolio. However, I believe it somewhat erroneous to equate the safety of a bond to the safety of any kind of stock. First, as we mentioned earlier, barring a corporate meltdown, bonds possess a return of capital feature that utilities and REITs don’t. Second, if a company does run into a problem, bondholders sit higher in the corporate structure for recouping an investment.
Thus, despite their dependable, recurring revenue streams, I would maintain that REITs, utilities, and equity of any type for that matter, should never be considered an equal-risk replacement for an investment grade bond. In the current market, investors are apt to forget the dive that stocks took between 2007 and 2009. And while I’m certainly not saying we’re on the verge of another 50% swoon, equity investors are always subject to severe corrections and potentially permanent capital loss. And while bond investors are subject to interim risks as well, if one holds until maturity, the risk is almost always limited to opportunity cost, not capital loss.
Though it may seem tempting to allocate away from bonds in a low rate environment, thorough consideration of risk factors should be undertaken. For some the move may make sense from a perceived total return perspective, while for others it may subject a portfolio to much more risk than is necessary or prudent given personal circumstance. In the end there really is no right or wrong way to construct and manage an investment portfolio, as long as 1) it does not subject you to undue real or perceived risk and 2) the allocation is capable of achieving your end investment goals.
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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