Is It Time to Get Back Into Bonds?

PHOTO: Interest rates on new subsidized Stafford loans double on July 1, 2013.

Back in the summer, fears that the government might soon start tapering economic stimulus triggered a bond sell-off. Now, many investors who dumped bonds and put that cash into money market accounts are still earning nearly nothing.

Compared with those returns, fixed-income investments earning low single-digit returns are quite attractive.

Many of these investors are looking to get back into fixed income investments, but they're concerned that the bond market could be roiled again when the Fed takes it foot off the stimulus gas pedal.

NOT YOUR GRANDFATHER'S INVESTING

If you're getting back into bonds – or adjusting or establishing a diversified investment portfolio with a bond component – this is a time to think outside the conventional bond box, beyond owning individual investment-grade corporate bonds and Treasuries. Instead, you might want to consider bond-related substitutes that can deliver income while providing far more flexibility than bonds themselves.

Interest rates have been historically rock-bottom low in recent years, and if they rise, you don't want to be holding long-term bonds or other long-term fixed-income investments. When higher rates are accompanied by rising inflation, this means two things: That if you hold on to long-term bonds until maturity, you may receive returns lower than inflation and thus, the buying power of the money invested will have decreased, defeating the purpose of buying the bond.

If you want to sell before the bond matures, you may have to take a loss. So the key is to build or adjust your bond portfolio with flexibility in mind, looking for liquidity potential – the ability to get out without pain.

SHOULD YOU PAY OFF YOUR MORTGAGE?

The possibility of another government-shutdown/debt ceiling crisis in Congress introduces uncertainty and near-term risk, making flexibility in your fixed-income holdings all the more critical.

Consider these alternatives to owning individual investment-grade corporate bonds and run-of-the-mill Treasuries:

• Exchange Traded Funds (ETFs) that invest in different types of bonds. By buying shares in these flexible bond index funds, you can own a share of a diversified portfolio of bonds without being locked into set maturities since the fund can own hundreds of bonds with different maturities. Unlike bond mutual funds, shares of ETFs are traded on exchanges throughout the trading day, so you can sell any time during the trading day.

With most bond mutual funds, you can't sell until the end of the trading day, so if things are going south, you must sit there and take the pain. Not so with ETFs. An example of such ETFs is the iShares Core Total Aggregate US Bond ETF (AGG). As with stocks, you can buy ETFs using a price limit, saying "here's the most I'm willing to pay" and then letting that limit stand.

• Floating rate bond funds. These funds track bonds with variable rates based on underlying indexes that are widely followed. Though the rates of these bonds aren't fixed, they are less sensitive to the forces that tend to punish fixed-income investments, so they can be used to hedge against rising interest rates. However, it's important to keep in mind that continued low rates in the overall bond market could keep floating rates generally depressed for years.

To stay flexible and manage such risks, consider ETFs in this category; you can get out whenever you like. Examples include SPDR Barclays Capital Investment Grade Floating Rate (FLRN) and Market Vectors Investment Grade Floating Rate Bond ETF (FLTR).

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