investing

Where to find value in the bond market

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Highlights
  • Yield-starved investors may be tempted to take on more risk than they should.
  • For principal preservation, cash is safe, but it won't keep up with inflation.
  • Some managers focus on income and preservation, while others go for total return.

Things are looking dicey in the bond market these days. Recently, the Financial Industry Regulatory Authority, or FINRA, issued a warning to investors that a rise in interest rates will be bad news for bonds.

Of course, this warning is not the first of its kind. With nowhere to go but up, the eventual increase in interest rates will push the value of bonds with longer maturities down. That makes some of the higher-yielding bonds available these days even more risky -- long maturities will be the most affected by a rise in interest rates.

With a yield-starved investor base clamoring for income, some investors may be tempted to take on more risk than might be wise.

Rates are down, risk is up

The safest option is always cash, but safety comes with a price. Though you're guaranteed not to lose principal, there's also no chance of interest income or growth. For very conservative investors for whom principal preservation is most important, the high opportunity cost may be worth it.

"The way I look at it, if you're a conservative investor and have bonds that are maturing, you probably want to keep that in cash and be patient," says William Larkin, fixed-income portfolio manager at Cabot Money Management in Salem, Mass.

At a recent conference Larkin attended, bonds were classified as "high risk/no-return investments."

"I'm afraid a lot of retail investors got into bonds and have enjoyed some price appreciation, but you don't want to be putting more money into the marketplace right now. It's a little bit overpriced," he says.

Not all fixed-income managers take such a conservative stance. High-quality corporate bonds with intermediate maturities may be worth the gamble -- depending on your view on interest rates.

"I think a person needs to sit down and quantify what they think rates will do -- are they going to go up 0.5 percent, 1 percent or 5 percent over the next couple of years?" says Donald Cummings, founder and portfolio manager at Blue Haven Capital, an asset management firm in Geneva, Ill.

"Right now for premium coupons in eight-, nine- and 10-year, up to about the 12-year area of the curve, you can get anywhere from 3.5 (percent) to 4.75 percent, depending on what kind of credit you want to buy and structure. That bond will be a pretty darn good performer in a portfolio versus sitting in a money market," Cummings says.

Getting down to brass tacks

Where investors look for value in the bond market will be contingent on their goals. That's the deeply unsatisfying answer to nearly every investing question. In short, where you invest depends on goals, time frame and risk tolerance.

"Our approach has always been preservation and income. There are other advisers that look at (a bond portfolio) as a total return vehicle," says Herbert Hopwood, Certified Financial Planner professional, CFA and president of Hopwood Financial Services in Great Falls, Va.

"That is a very different-looking portfolio than what we're talking about," Hopwood says. "And some people do a combination of the two: have some where you're getting a return of principal and some income, like a ladder -- then they try to be strategic or tactical with the other part, for instance, using high-yield and international bonds."

Stability-seeking investors will typically give up a little bit of capital appreciation and income in exchange for safety. Similarly, investors who push for higher returns in their bond portfolio have to accept the potential downside.

What should you do?

Avoid long-term bonds, period. That can be anywhere north of 10 to 15 years.

As a foundation, Treasury securities are still stable and make a good bet for safety, though yields are currently under the rate of inflation.

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