Where to find value in the bond market

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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.

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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.

Depending on your risk tolerance and philosophical bent regarding the role of a bond portfolio, venturing into emerging markets and even other developed countries can add diversity and relatively higher yields.

“Look at the bonds of countries that have budget surpluses and not deficits like we do, and I would mention Brazil there. Their bonds yield about 9 percent; Mexico, 5 percent. In the developed world slightly better yields can be found in Australia,” says Andrei Voicu, managing director and chief investment officer at Fragasso Financial Advisors in Pittsburgh.

And even some eurozone bonds could be a good deal now. They’re still looked at askance but the yields may tempt investors. Take, for instance, Italian sovereign bonds.

“They pay about 4 (percent) or 4.5 percent on the 10-year right now, and I believe that is a very attractive proposition — even on the shorter side, maybe three years for instance,” says Voicu.

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Investing in the bonds of governments other than the U.S. brings in a few different risks, such as currency and politics.

But there are safe options in the bond market that offer decent values to investors. For instance, people may want to have some money in a Ginnie Mae bond fund, according to Hopwood.

“Those don’t tend to move very much and the default rate is nil in Ginnie Mae, so the credit risk is not there,” he says.

Ginnie Mae, the Government National Mortgage Association, is a government-owned agency. Securities issued by Ginnie Mae are secured by the full faith and credit of the U.S. government, like Treasury securities.

They have a high minimum initial purchase requirement of $25,000 and can be complicated for individuals to buy. So investors may find Ginnie Mae bond funds an easy alternative. Just be sure to keep expenses low as interest rates are way too low to make up for high fees.

Importance of diversification

It’s difficult to choose a path without the benefit of psychic powers. The Federal Reserve’s rate-setting group, the Federal Open Market Committee, has stated that based on current economic conditions, interest rates could rise by 2015. That’s their best guess — for now. The truth is that no one knows. That’s why investing strategies that spread risk among many assets remain popular.

“Two years ago, I didn’t think we would still be at these interest rates. There is a cost for keeping everything in (Treasury) bills,” Hopwood says.

“In our opinion a broadly diversified portfolio of different strategies that will act differently at any given time would make the most sense rather than trying to guess what will happen,” Voicu says.

Another option for times when you don’t know what’s going on: laddering. Laddering bonds or certificates of deposit can moderate the risk of rising interest rates and inflation by spreading investment dollars over a range of maturities.

For instance, an investor with $10,000 to put into bonds could invest $2,000 in bonds with a range of maturities at one-year intervals, up to five years. As each bond matures, the principal could be funneled back into the ladder at the furthest rung, or five years out. After the first cycle, the ladder will be made up of five-year bonds with a bond maturing every year.

“I still believe in laddering because you just don’t know,” Hopwood says.

More than ever, there’s no magic bullet in the bond market.