Despite Dire Warnings, the Right Ones Can Pay Off

Many financial advisers have been saying that it’s time for investors to dump bonds. They say interest rates, which have generally dropped over the past three decades to very low levels, are likely to rise substantially over the next several years. That means investments previously considered safe could generate losses because the value of bonds and bond funds typically falls as rates rise. And investors in low-yield bonds could miss out on better yields as rates rise. That leaves investors who are seeking reliable income from a safe investment in a quandary.

The solution favored by some advisers: Stick with bonds despite the fears. These bond contrarians say that a major bond meltdown is unlikely…and that a carefully selected portfolio of bonds still can be a wise investment, as long as rates don’t jump too sharply. Their reasoning: If you invest in short- and intermediate-term bonds directly and hold them to maturity, it won’t matter if they fluctuate in price because you will get their full value at maturity. And if you own a bond fund run by a smart manager, as long as the rate increase is moderate, losses in share price will be mitigated over time by the rising yield that the fund provides as its holdings mature and the assets are reinvested at higher rates. Moreover, rising interest rates typically signal a healthy economy, which could benefit the stock portion of your portfolio and produce good returns overall. If, instead, the economy falters, that would tend to restrain interest rates and strengthen bond prices, helping offset any stock price weakness.

To explain why bonds might be right for you even in this new rising-rate ­environment, Bottom Line/Personal spoke with two top financial advisers. Randy A. Garcia, who advocates a 50/50 split between stocks and bonds, explains his reasons below…and Greg Miller explains here why he keeps 100% of client portfolios in “convertible” bonds—a part-stock, part-bond hybrid.

A 50/50 Split

Over the past several years, some of my clients, many of them retirees, have come to me in a panic over fears that interest rates will zoom higher and their bond portfolios, which represent the majority of their wealth, will drop 30% in value in a year, as some bonds have done at certain times in the past.

Bonds do face some significant risks now, and even investors who follow my firm’s advice aren’t going to get the kind of capital appreciation that they have become accustomed to getting from bonds in the past. But a bond meltdown is highly unlikely. For that to happen, the Federal Reserve would have to push up short-term interest rates by several percentage points over a very short period of time. But current economic conditions warrant just the opposite approach. US economic growth, as measured by gross ­domestic product (GDP), is likely to be under 3% for 2015, and inflation is running much lower than the Federal Reserve’s target. That means the Fed will proceed slowly and cautiously.

In past cycles when rates have risen at a reasonable pace, the total returns on bonds (price changes plus income) have been positive. For example, from 1966 to 1981, the annualized return on ­intermediate-term US government bonds was 5.8%, although that period was marked by high inflation, which makes this performance less impressive. More recently, as rates rose over a 24-month period between mid-2004 and mid-2006, intermediate-term bonds produced a 4.6% total return.

What this means is that bonds can continue to be the best option to anchor your portfolio and provide income. By dividing your investment portfolio evenly between bonds and stocks, you still can profit from possible continued gains in the stock market but give ­yourself a cushion in case stocks sag.

Of course, that doesn’t mean you just continue to hold your existing bond portfolio. Many investors would be wise to make substantial changes…

Eliminate long-term bonds. The longer a bond’s maturity, the more its price will drop as interest rates rise. I prefer bonds with maturities in the three-to-eight-year range, a sweet spot where the risk of rising rates is tolerable for the yield you might get.

Focus on bond asset classes that have historically done well in rising-rate environments. My firm’s typical portfolio for clients is currently designed to provide a 2% to 2.5% annual yield, about the same as the Barclays US Aggregate Bond Index (considered a proxy for the total bond market). But because our portfolios contain far less in interest rate–sensitive bonds than the index does, they should produce lower volatility and superior returns in a rising interest rate environment. Our allocations in the bond portion of a 50/50 stock/bond portfolio…

88% in funds focused largely on mortgage-backed securities: These are pools of mortgage loans packaged together into a bond and sold by US agencies such as Ginnie Mae and Freddie Mac. They tend to provide higher yields than comparable government bonds and greater flexibility to take advantage of rising interest rates. Unlike with many other types of bonds, payouts are monthly instead of semiannually and you get partial repayment of your principal each month instead of having to wait until the bond matures. That means that you can reinvest both the interest and principal more quickly into securities with higher rates. Examples of funds…

For conservative investors: JPMorgan Core Bond Select Fund (WOBDX) divides its assets among mortgage-backed securities, corporate bonds and US Treasuries. Recent yield: 1.98%. 10-year performance: 4.8%.*

For moderately aggressive investors: DoubleLine Total Return Fund (DLTNX) is run by bond impresario Jeffrey Gundlach. He focuses mostly on mortgage-backed securities with a small exposure to US Treasuries. Recent yield: 3.63%. Five-year performance: 5.7%.

US Treasury securities, which are in both of the funds above, aren’t immune to interest rate spikes, but they do provide protection against global crises in a way that literally no other investment on Earth has. Treasuries rally strongly in environments when investors panic and abandon stocks.

12% in bank-loan securities: These are short-term, adjustable-rate loans that banks make to corporate borrowers. Unlike conventional bonds, yields typically reset every 90 days, keeping pace with rising short-term interest rates. However, many bank loans are below investment-grade. For safety, I don’t overload client portfolios with these securities.

Fund example: Fidelity Floating Rate High Income Fund (FFRHX). Recent yield: 4.09%. Five-year performance: 3.6%.

*Performance figures are through September 15, 2015.

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