Should You Avoid Bonds Right Now?

Should You Avoid Bonds Right Now?

Oksana Aronov, a managing director at JPMorgan Chase, is recommending against investing in U.S. Treasuries right now, according to Bloomberg News.  Although the ten-year Treasury note is currently yielding 1.58% (at a time when equivalent Japanese and European Central Bank sovereign bonds have negative yields), its real yield (i.e. the yield after factoring in inflation) is not only negative but below that of Japanese government bonds.  Aronov argues that U.S. Treasuries should no longer be considered risk free at this point in time.

Even though Treasury bonds still jump in value whenever there’s some international crisis and investors scarf them up regardless of their prices or yields, Aronov is correct that they do not represent long-term value right now.  But it would be foolhardy to eschew bonds entirely, since they are still necessary to keep investment portfolios well-diversified.  Investors need to be aware that there are a plethora of different bond asset classes besides Treasuries from which to build up and diversify the bond side of their portfolios.

Here are some other bond asset classes in which a retail investor can easily participate through publicly-traded mutual funds or ETFs:

  • Corporate bonds. Unlike Treasuries, these bonds additionally carry the risk of the company defaulting and the investor losing all or part of his/her principal (credit risk).  But you can stick to bonds from high-quality companies that exhibit very low default rates even during recessions.  When was the last time IBM defaulted on a bond?  And when the spread (the difference) between corporate bond yields and Treasury bond yields is high, that’s the time when you’re getting the best return for the additional risk.
  • High-yield bonds. These are bonds from companies whose credit risk is higher than those in the asset class above.  But even if a company goes bankrupt, investors usually get some percentage of their principal back.  Again, the higher yields are compensation for the added credit risk, and when spreads are high, the risk/return is better.
  • Floating rate loans. These are loans to companies whose credit is so bad that they cannot even issue bonds.  While that sounds ominous, the reality is that if such companies do go bankrupt, lenders typically get a larger percentage of principal returned than do high-yield bond owners.  But this type of bond’s unique benefit is the fact that the interest the company has to pay the lender (you) varies based on prevailing rates.  That eliminates interest rate risk, a big issue today with fixed-rate bonds since their value will drop when rates rise.
  • Municipal bonds (munis). Rather than investing in federal government debt, you can invest in state or other municipality debt.  And although such investments are not risk free (think Detroit, for example), the earnings are federal income tax-free and – if the municipality is in California – CA income tax-free as well.
  • Mortgage-backed securities (MBS). These are in effect mortgages that have been sold by the originating banks to investment companies that issue shares to individual investors.  Again, there is credit risk (in this case the creditworthiness of the myriad of individual borrowers who are paying off the mortgages), but interest rate risk is somewhat reversed.  That’s because when rates are rising, fixed-rate borrowers tend to keep their mortgages healthy since their mortgage rate becomes better than current rates.  When rates drop, normally a good thing for other types of bonds, many mortgage-holders will refinance at the lower rate, resulting in early payoffs and reduced expected income to the lenders.  For this reason (among others) MBS is a good diversifier even within an all-bond portfolio.
  • Foreign sovereign bonds. These are bonds issued by other countries’ governments.  Although yields in the U.S. and Europe are low, different countries may be experiencing different economic or political conditions requiring them to offer higher returns.  For example, Mexican government ten-year bonds are currently yielding over 6%. But it’s important to recognize that during periods of economic stress such countries may be forced to shave the amount of principal owed to their lenders as did Greece several years ago.  Therefore I would not recommend investing in any one particular country but rather sticking with a fund that is diversified across numerous ones.  You might also consider a fund that eliminates the currency risk that goes along with sovereign debt investments.  See for more on that point.

Four times as many bonds are traded worldwide every day as compared to stocks.  Although Treasuries are not providing much return right now, don’t be afraid to invest in bonds.  You have a lot of options from which to choose.

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