Fixed Income: Stop Chasing Yields
In our recent series, “Investing for Retirement Income,” we covered the reasons why we do not recommend shifting into high-yield (“junk”) bonds or dividend-yielding stocks when higher-quality bonds aren’t delivering as hoped for. Rather than stretching for extra yield with stand-alone solutions, we typically suggest taking a total-return approach, seeking an appropriate risk/reward balance among all sources for earning and preserving your investment returns. These include tending to share value, interest and dividends, and aggressive cost management.
The Role of Bonds in Your Portfolio
With a total-return approach, we typically want you to reserve your fixed income/bond investments for their primary purpose in life, which is to provide a stabilizing counterbalance to your equity/stock holdings, while offering a modest investment return – typically in that order.
Over the long-term, stocks have delivered higher returns than bonds, based in part on the different kinds of risk you’re assuming by investing in them. But to actually receive those higher expected returns, you must be prepared to sit tight during the wilder ride that equity risks entail.
Setting aside a portion of your investments in relatively high-quality bonds or similar holdings is essential to helping you maintain your resolve during periodic stock market downturns. Taking on too much bond market risk detracts from that important role, and is not expected to add more value than could be had by building an appropriately allocated stock portfolio.
Enhancing Your Fixed Income Investments
Even though it’s a good idea to take a “safety first” approach to your bond and bond-like holdings, we understand that it can be hard to see them earning next to nothing without wondering whether there is anything you can do to improve on things. Fortunately, there is. Here, we offer several ways to make the most of your fixed income.
Heed the Yield Curve
Just as the stock market has its ticker tape of ongoing pricing action, the bond market has its continuously changing yield curve, which offers us a rough guide on how far it may be worth extending your bonds’ due dates (also known as terms or maturities). This idea applies whether you are investing in individual bonds or bond funds.
In other words, even in your fixed income investments, a bit of risk exposure may be acceptable. You don’t always have to invest in the highest possible credit rating and shortest possible terms.
To be clear, we are NOT endorsing chasing bond yields by frequently jumping in and out of particular bonds, bond funds, or the market as a whole. But one way to come close to having your cake and eating it too is to build a laddered bond portfolio, investing in a basket of relatively high-quality, short- to mid-term bonds that are set to come due at varied times (or to invest in a bond fund that does this for you). Like rungs on a ladder, staggered due dates structured for your lifetime goals offer regular opportunities to reconsider your investments and their liquidity in light of then-prevailing market conditions.
One of the biggest problems faced by those using this strategy is our all too common tendancy to try and predict the future. When bonds mature, instead of immediately investing in a new bond at the longest maturity, we might decide to wait a bit for better future interest. This defeats the purpose of this disciplined approach and turns it into a likely disastrous market timing approach.
Consider the Alternatives
Depending on market conditions and your own circumstances, there may be times when other bond-like investments may fulfill the risk-dampening/modest-return role in your portfolio even more effectively than bonds or bond funds. In the US, Certificates of Deposit (CDs) may offer slightly higher returns for similar levels of risk. Guaranteed Investment Certificates (GICs) are roughly the Canadian equivalent to CDs.
But it’s important to look beyond just the face-value interest rate before taking a leap. A higher rate may also bring added risks – such as a longer lock-in period when you won’t be able to withdraw your money without incurring penalties. Different investments may also generate different taxable outcomes, so it’s worth comparing your choices on an after-tax basis.
Watch Your Costs
If you’re investing in bond mutual funds, you should be able to find a fund’s expense ratio in its prospectus or by looking up its ticker symbol on an independent investment research site such as Morningstar’s. Because added costs only detract from your end returns, we usually recommend looking for the lowest-cost fund for your needs.
That doesn’t necessarily mean finding the cheapest fund out there. If a fund’s investment objectives do not align with yours, saving on the cost of investing in it won’t help. First identify the funds that do meet your goals, and then let the costs involved be an important factor in making a final selection.
If you’re building your bond portfolio with individual bonds, be on the look-out for trading costs known as markups and markdowns. While these are easily the subject of another article entirely, suffice it to say that they are always there – even if your broker tells you that there are no trading costs. What he or she really means is that there are no obvious trading costs.
Markups/markdowns are the difference between the “wholesale” costs that bond brokers pay for the bonds and the “retail” prices you pay. To avoid paying more than you should for your bonds, it’s best to align yourself with an advisor or fund manager who has the experience and resources to keep a close eye on these and other hidden costs that may eat away at your end returns.
Revisit Your Risk Tolerances
What is the balance between your stock and bond holdings today? Half and half? Mostly one or the other? Do you also have allocations to international markets or real estate?
If you’re not sure what you’ve got, we recommend finding out first, before making any adjustments. Identify your asset allocation wherever it may be (taxable and retirement accounts, pension plans, annuities, profit-sharing programs, etc.), and in whatever form it may take (stocks, bonds, REITs, hard assets, private ventures, etc.). You may discover additional opportunities to shift your investments around to better reflect your unique risk/reward profile.
Are you holding more fixed income than you realized – maybe more than you really want or need? You may be able to shift some of it into stock investments to pursue higher expected portfolio-wide returns.
Are your stock holdings heavily allocated to less-risky stocks (with lower expected returns)? Even if your stock-to-bond ratio is appropriate, your stock holdings may be internally out of balance for your goals. You may be able to shift some of your holdings into the kinds of stocks (asset classes) that have offered higher expected returns, while leaving your safety-net bond holdings intact.
These are just a couple of possibilities. Bottom line, if you’ve not taken the time to assess your total portfolio’s risk/reward balance lately, this is one of the most important steps you can take to ensure that your investments are doing all that they can for you.