Plain Vanilla Bonds: Why They May Be Best

Right now, we're in a low-rate environment. Even though the Federal Reserve has started hiking rates, there is a good chance that rates (and yields) will remain low for quite some time.

Faced with the prospect of continued low yields, it might be tempting to spice things up with more exotic bond offerings. Before you decide to change your strategy, it's a good idea to take a step back. Plain vanilla bonds might be a better fit.

The Plain Ones and Liquidity

"Boring is easier to buy or sell," said Mary Talbutt, lead portfolio manager for the SLG Fixed Income Fund. "If you have a benchmark bond or other bond with larger issuers, it's possible to purchase with a much tighter spread. If you plan to sell, you are more likely to find someone who wants to buy."

Plain vanilla bonds are easier to trade, and they have tighter spreads. "Look at Treasuries," Talbutt continued. "These are very tight and easy to trade. They give you decent variety and maintain market value." She points out that more esoteric bonds come with wider spreads, which can make it harder to come out ahead or even break even, depending on when you buy and sell. And, of course, you might not even be able to find a buyer for the more exotic offerings.

Even if you decide to move into corporate bonds and away from government bonds, you can benefit from plain vanilla bonds from highly rated companies, said Talbutt. "If you buy plain-vanilla corporate, there are a lot of opportunities for people to buy and sell," she said. "Traders are making a market in these all the time, and liquidity is the key."

The Stability Factor

Another factor to consider is stability. Investors and retirees might be tempted to squeeze out a little more yield or take advantage of soon-to-be-rising interest rates with the help of step-up bonds. "These bonds are enticing if you have a rising interest rate environment because maybe it steps up right after the Fed raises interest rates," said Talbutt.

However, it's important not to be deceived by appearances. Talbutt says that while it's nice to think that your bond yields will stay in line with decisions from the Federal Reserve, the reality is that you don't know if you will actually reap the benefits. "A lot of these step-up bonds have call features," she said. "So it might get called away before stepping up." If your bond is called before you see the advantage of an interest rate hike, you need to find a new income-producing vehicle for your portfolio.

Another issue related to stability is the bonds you choose to invest in. "With people reaching for yield, they might decide to invest in something that isn't exactly investment grade," said Talbutt. "It's not really plain vanilla, even if the yield is fixed because the company might have poor ratings and you risk losing your principal as well as future earnings."

With plain vanilla bonds in your portfolio, you can have reasonable confidence that you won't lose your principal and you know what your income will be each month. When living on a fixed income, stability is important. If you want to include yield, diversifying a portfolio to include some index funds might help, while you rely on plain vanilla bonds for your current income needs, says Talbutt. "It's easier to target your income stream with plain vanilla."

The Bottom Line

If you know you will need a certain amount of income during retirement or at another point, plain vanilla bonds can be a good way to shore up your portfolio. "In a falling environment, you keep your rate no matter what," said Talbutt. "In a rising rate environment, it's going to mature at par, even if you don't see the same interest rate increase—and you'll be reasonably secure in your monthly income."

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