(07/16/13) It's Time for a New Bond Strategy

In the current environment, investors should decrease their bond mutual fund or ETF holdings, and consider adding individual bonds to their portfolios, says Joon Choi in Systems & Forecasts.

The recent rise in long term interest rates has hit bond investors very hard. In fact, the Total US Bond Market ETF (AGG) fell 4.52% from May 2nd to June 24th of this year, which is the largest pull-back since 2009.

Of course, if the interest rates come back to May 2nd levels, then AGG would recover all of its losses. But this scenario is unlikely since the Fed may taper off bond purchases no later than next year. In addition, I believe the real 10-year Treasury yield will not revisit the negative levels that we have seen in recent years.

Assuming that the interest rates hover around current levels, it would take almost two years for the average bond investor to recoup this recent loss (since AGG yields about 2.5% a year).

If interest rates rise further, AGG will continue to fall. What worries me about this scenario is that there is no limit to how much one could lose.

This is because there is no principal guarantee when investing in bond ETFs and bond mutual funds. The managers for these investment vehicles are not required to hold bonds until maturity, which means that they could realize a loss by selling the bonds for less than they paid.

Moreover, proceeds from old bonds maturing are sometimes used to buy bonds at a premium (above $100), which means the fund manager will realize a principal loss even if he/she holds to maturity. If this is the case, why use them at all? It’s because they provide diversification and are cost effective.

In this article, I would like to look at an alternative to bond mutual funds/ETFs—individual corporate bonds, addressing both positive and negative characteristics and offering a few bond recommendations.

Are individual bonds riskier than bond mutual funds/ETFs? Yes, and no. The reason to buy an individual bond and hold until maturity is to manage interest rate risk.

When you buy an individual bond, you know at the time you invest what your total return will be if you hold until maturity. The assurance of a return even if interest rates move against you (absent a default risk, see below) represents a high degree of safety.

In contrast, with a bond mutual fund or ETF there is no guarantee of investment return over any time period. The only interest rate risk in holding individual bonds until maturity is the possibility of lost opportunity: If rates rise you could have locked in a better return.

Nonetheless, regardless of what happens to interest rates, you will receive the expected return provided you hold the bonds until maturity. (If you sell before maturity, you do bear the risk of losing principal in the event that interest rates have risen.)

On the other hand, individual bonds are riskier than a pool of bonds that ETF and mutual funds hold because of default risk. If a company becomes insolvent and defaults on its debt then bond investors will likely receive a haircut on the principle payment (e.g. 70 cents on a dollar).

BBB rating (from Standard & Poor’s rating agency) is the cut-off for investment grade status and it’s easy to see why. BBB-rated corporate bonds had an average default rate of 0.23% for the past 30 years but BB rated issues had a 1.02% default rate, which is four times that of BBB.

If you buy an A-rated bond, then the default rate decreases further to 0.06%, which is a sweet spot. Buying bonds with an A rating would “almost” eliminate the default risk (assuming the credit rating does not deteriorate until bond maturity date).

What corporate bonds are available? A Goldman Sachs bond with 5.375% coupon due in 3/15/20 has an A rating and is currently available at $109.39. Yes, you would be buying at a premium but the higher coupons would offset the principle loss in 2020 when the bond matures.

The yield to maturity (YTM) measures what the true yield is by adjusting for the price discount/ premium to the bond coupon rate. The Goldman Sachs bond mentioned has a YTM of 3.8%, which is pretty good for this seven-year bond since the longer-term 10-year Treasuries yield about 2.5%.

As another example, the Royal Bank of Scotland bond with 5% coupon due in 10/15/19 (3.7% YTM) is also available.

Overall, I believe the long-term interest rates will be hovering at current levels for a few months. But if the Fed starts to tighten the monetary policy by reducing/tapering the bond purchase, bonds could come under pressure as they did recently.

This is why I am recommending to replace some bond fund/ETF positions with individual bonds just in case rates do rise further. Owning individual bonds give a security of principal repayment which may be crucial for those investors who are more conservative.

Corporations defaulting on their debt are a legitimate concern for buying individual bonds, but bonds with an A rating have such a small chance of defaulting that it should not deter you from adding them to your portfolio, as you can see from the table to the right.

I would not recommend buying more than 3% of your portfolio in any one bond and hold more than five bonds in your portfolio for diversification. In addition, I suggest trying to avoid purchasing the bonds from same industry.

Lastly, try not to exceed more than 10 years in maturity because of the risk of locking in a lower interest rate now than would be available if rates rise down the road.

Ultimately, the decision on how long-term a bond to buy depends not only on your assessment of the bond market, but also on whether the rate you lock in now is likely to meet your income needs going forward.

The bottom line is that in an uncertain interest rate climate, buying individual bonds and holding them to maturity is as close to a guaranteed potential return (beyond the meager yields on bank CDs) as you are going to find.