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Don't Forget Bonds
The recent economic uncertainty and market turmoil sent many investors looking for safety. Bonds and related bond funds became safe havens for investors looking for any port in the storm. Nevertheless, this flight to quality was not without consequence. With worries about various nations' debt-to-GDP ratios, many analysts are predicting the possibility of a bubble in Treasuries, sovereigns and bond exchange-traded funds (ETFs). Even the bond king, Bill Gross says the 30-year bull market in bonds is likely over. However, fixed-income investments and bonds still have a place in portfolios. Investors just need to look past Treasury bonds.
IN PICTURES: 8 Ways To Lose Money On Bonds
Still Important
Most financial experts say that portfolios should have some allocation towards bonds. During the global crisis, they gained in popularity due to their placement in bankruptcy proceedings. As investors began toning down their risk, being higher on the food chain became more important. Fixed-income investments are one way to do this. In worst-case scenarios such as bankruptcy, creditors and bondholders usually get at least some of their money back, while shareholders often lose their entire investment.
Bonds are also very efficient at smoothing out volatility and preserving capital. The regular income distributions bonds generate help cushion downside while still providing upside. They also provide predictable returns and balance to a portfolio. By ignoring them completely investors are missing out on many of their diversification benefits. While there are new perceived and real risks in bonds, such as rising rates and potential for increased defaults, there are places in the market that offer better prospects. By avoiding plain vanilla Treasury bonds and investments like the iShares Barclays Aggregate Bond (NYSE:AGG), investors can still have the safety that makes bonds attractive and gain additional yield.
Where to Look
Not every sector of the bond market is as sensitive to interest-rate hikes as U.S. Treasuries. Bonds issued by companies without pristine balance sheets tend to fair well in rising-rate environments as many are paying much higher coupons to begin with. While junk bonds are no longer paying the eye-catching double-digit yields that they were in early 2009, many still provide coupon payments in the 7-8% range. In addition, the improving global economy has helped reduce their risk of default. The SPDR Barclays Capital High Yield Bond (NYSE:JNK) follows 213 different high yield bonds and currently yields 8.39%. Similarly, the PowerShares Fundamental High Yield Corp Bond (NYSE:PHB) yields an impressive 7.9%.
It's almost a guarantee that the Federal Reserve will raise interest rates in the near-medium term. Worries about inflation and the raising of interest rates will punish traditional bond prices. Treasury inflation protected securities (TIPS) provide payouts that increase right along with inflation. They become more valuable as inflation begins to rear its ugly head. The PIMCO 1-5 Year US TIPS Index ETF (NYSE:STPZ) and the SPDR DB Intl Government Inflation-Protected Bond (NYSE:WIP) offer ways to add exposure to these bonds.
Bonds with shorter maturities, unlike the Vanguard Extended Duration ETF (NYSE:EDV), won't be hit as hard. By keeping their maturities short, investors can take advantage of this. The iShares Barclays 1-3 Year Credit Bond (NYSE:CSJ) follows 683 different short-term investment grade corporate, and non-U.S. agency bonds. The fund currently yields 2.04%, but as rates rise, so will the ETF's yield.
Finally, investors hedge their bond portfolio against the inevitable rate hikes. Shorting long term bonds circumvents the inverse relationship between yields and price. Both the ProShares UltraShort 20+ Year Treasury (NYSE:TBT) or the Direxion Daily 30-Year Treasury Bear 3x Shares (NYSE:TMV) allow investors to short the long end of the bond spectrum and have become quite popular with investors.
Bottom Line
While there is ever-increasing bearishness in the bond market, there are still opportunities for investors. By ignoring bonds all together, investors miss out on some important diversification benefits for their portfolios. By focusing their attentions away from traditional treasury bonds towards these other sectors, investors can still maintain levels of safety and yield. The previous ETFs are just some of the examples of where to look in the bond market. (To learn more, see Bond ETFs: A Viable Alternative.)
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
IN PICTURES: 8 Ways To Lose Money On Bonds
Still Important
Most financial experts say that portfolios should have some allocation towards bonds. During the global crisis, they gained in popularity due to their placement in bankruptcy proceedings. As investors began toning down their risk, being higher on the food chain became more important. Fixed-income investments are one way to do this. In worst-case scenarios such as bankruptcy, creditors and bondholders usually get at least some of their money back, while shareholders often lose their entire investment.
Bonds are also very efficient at smoothing out volatility and preserving capital. The regular income distributions bonds generate help cushion downside while still providing upside. They also provide predictable returns and balance to a portfolio. By ignoring them completely investors are missing out on many of their diversification benefits. While there are new perceived and real risks in bonds, such as rising rates and potential for increased defaults, there are places in the market that offer better prospects. By avoiding plain vanilla Treasury bonds and investments like the iShares Barclays Aggregate Bond (NYSE:AGG), investors can still have the safety that makes bonds attractive and gain additional yield.
Where to Look
Not every sector of the bond market is as sensitive to interest-rate hikes as U.S. Treasuries. Bonds issued by companies without pristine balance sheets tend to fair well in rising-rate environments as many are paying much higher coupons to begin with. While junk bonds are no longer paying the eye-catching double-digit yields that they were in early 2009, many still provide coupon payments in the 7-8% range. In addition, the improving global economy has helped reduce their risk of default. The SPDR Barclays Capital High Yield Bond (NYSE:JNK) follows 213 different high yield bonds and currently yields 8.39%. Similarly, the PowerShares Fundamental High Yield Corp Bond (NYSE:PHB) yields an impressive 7.9%.
Bonds with shorter maturities, unlike the Vanguard Extended Duration ETF (NYSE:EDV), won't be hit as hard. By keeping their maturities short, investors can take advantage of this. The iShares Barclays 1-3 Year Credit Bond (NYSE:CSJ) follows 683 different short-term investment grade corporate, and non-U.S. agency bonds. The fund currently yields 2.04%, but as rates rise, so will the ETF's yield.
Finally, investors hedge their bond portfolio against the inevitable rate hikes. Shorting long term bonds circumvents the inverse relationship between yields and price. Both the ProShares UltraShort 20+ Year Treasury (NYSE:TBT) or the Direxion Daily 30-Year Treasury Bear 3x Shares (NYSE:TMV) allow investors to short the long end of the bond spectrum and have become quite popular with investors.
Bottom Line
While there is ever-increasing bearishness in the bond market, there are still opportunities for investors. By ignoring bonds all together, investors miss out on some important diversification benefits for their portfolios. By focusing their attentions away from traditional treasury bonds towards these other sectors, investors can still maintain levels of safety and yield. The previous ETFs are just some of the examples of where to look in the bond market. (To learn more, see Bond ETFs: A Viable Alternative.)
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
by
Aaron Levitt
Aaron Levitt is a SABEW investment journalist and analyst living in State College, Pennsylvania. His work appears in several high profile publications in both print and on the web. Aaron is a graduate of The Pennsylvania State University where he studied Economics and International Business and he is an advocate for long-term investing with a global framework. You can follow his picks and pans at @AaronLevitt
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