There’s been a lot of commentary about how bond market fundamentals are deteriorating. Warren Buffett has recently weighed in on the subject in his annual letter to Berkshire Hathaway shareholders, saying, “Right now, bonds should come with a warning label.”
I find it hard to argue with the Oracle on most issues; this one is no exception. Interest rates will be going up – it’s just a matter of time. Sovereign debt problems in the eurozone are still casting a pall. Perhaps most importantly, government bonds currently pay less income than stocks for the first time in 50 years. Add it all up and it seems that a perfect storm is brewing for bonds.
So what should you do about it? Let’s be clear: liquidating your bond portfolio is not the answer. However, that doesn’t mean you should just ignore the clouds gathering overhead.
I’ve been speaking to many clients and associates, as well as with Tiger 21 members about what they’re doing with their bond portfolios. Most of them have been pursuing a number of strategies to prepare their bond portfolios for the “new normal.”
Trimming exposure and shortening duration/terms
Now is not the time to go “all in” on bonds. There is still a core bond exposure, but the percentage of the portfolio allocated to bonds has come down considerably over the past couple of quarters. Generally speaking, investors are getting by with less government bond exposure and becoming more intrigued with high-yield bonds.
Equities as the new bonds
At the end of last year, dividend yield for the TSX surpassed the Government of Canada long bond yield for the first time in 50 years (the difference would have been even more pronounced in after-tax terms). That’s a pretty strong argument for swapping at least some of your bonds for high-quality dividend-paying equities.
“Back to basics” with core bond positions
High net worth individuals currently have little interest in betting big on duration or on a single bond issue. Instead, most investors are spreading risk around the yield curve, either with a bond ladder or bond funds and/or exchange-traded funds (ETFs). Call it the “sleep at night” strategy.
Explore global high yield
There’s been a lot of interest (if you’ll pardon the pun) in high-yield corporate bonds over the past few years. In part, that’s because of the low yields on government bonds. Also, while high-yield corporate bonds are affected by company-specific factors (“credit risk”), interest rates don’t have as much impact on their prices as they do with “govvies.”
I don’t think high-yield corporate bonds are appropriate for all investors. And they should not be a “core” position: shoot for a maximum between 10% and 35% of your overall bond portfolio.
Bond diversification
Bond portfolios used to be very monotone, with developed-market government bonds making up the vast bulk of an investor’s bond portfolio. But that’s changing: emerging market bonds have really come into their own over the past few years. This is a welcome change. There’s no reason why bond investors shouldn’t consider geographic diversification as much as equity investors do.
Inverse investing
Some HNW individuals have recently taken short positions on U.S. treasuries and other bonds; inverse bond ETFs offer the same kind of exposure. Some are also placing money with expert managers (typically in the hedge fund space) who know how to do this kind of investing. I advise caution here: such investments can be viewed as risk management or speculation depending on how you use them. •
