In my previous blog post I highlighted why investors might consider continuing to hold bonds, namely the diversification benefits. Now for the more pressing question: how might they hold bonds?
In spite of our expectations (see our recent Annual Outlook ) for gradually rising interest rates and therefore potential headwinds for bond performance in 2014, investors should not feel entirely helpless. There are ways to hold bonds that may offer better return potential than a passive, broad market allocation, while at the same time staying true to the investor’s ultimate objectives and outcomes.
Case in point: An increased exposure to credit sectors of the market may give investors additional yield cushion while opening a door to additional security selection returns from active management. Having said that, investors should consider two issues before pursuing this strategy:
- Increasing credit exposure of a fixed income portfolio also increases its correlation to the equity market. This can become a harmful side effect for the overall portfolio, so investors might consider limiting the total amount of risk they take with this strategy.
- The current valuation of most credit sectors is slightly rich, as measured by credit spreads, compared to historical averages. This calls for a selective, value-minded approach to adding a credit yield cushion to the portfolio. Two such examples are non-agency mortgages, which continue to benefit from a recovering U.S. housing market, and bank loans. The latter has been a hot sector for inflows during the last 12 months, though mostly for the wrong reasons. Most investors seem drawn to the short-duration source of yield, but we prefer the sector for its relatively high credit spread versus high yield bonds. Interest rate properties have little to do with why we view bank loans as a select pocket of value.
A second bond strategy investors may want to consider is to open up their playbook to relative-value opportunities in international markets. Some non-U.S. investors are already accustomed to the use of currencies and international interest rates in their bond portfolios. Despite some risks, we believe that suitable investors should consider broadening their regional horizons by opening up to such return-seeking opportunities. It also makes sense to look globally now that central bank policies among industrialized economies are not all going in the same direction (e.g., easing policy) which should create opportunities in among currencies and bond markets.
No matter how you choose to hold bonds, we believe long-term outcomes will benefit from a diversification strategy within every bond portfolio and at the multi-asset level. Such diversification gives investors another potential return source in what is an admittedly challenging return environment, especially for bonds in the near-term.
 Barclays U.S. High Yield Corporate Index and Barclays U.S. Investment Grade Corporate Index as of 1/31/2014
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Bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield (“junk”) bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages.
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