Reaching for bond income, yield may not be worth risk to retirement portfolios

  • Income-oriented investors, like retirees, may be reaching into European, Japanese and emerging markets bonds.
  • Yields can be higher overseas, but risks are greater as well.
  • Upcoming central banking decisions from the Fed and other global banks also may put pressure on bond prices more than they have in the post-financial crisis period.

Despite some bad days recently, U.S. stocks remain near all-time highs, making them look pretty risky. And U.S. bond values are threatened by rising interest rates as the Fed moves further away from the post-financial crisis dovish posture, so they, too, look hazardous to investors' financial health. These conditions are especially tough on income-oriented investors like retirees.

Federal Reserve Board Chairman Jerome Powell testifies before the House Financial Services Committee in the Rayburn House Office Building on Capitol Hill February 27, 2018 in Washington, DC. Powell said recent market volatility will not influence Fed decision-making on raising interest rates.
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Federal Reserve Board Chairman Jerome Powell testifies before the House Financial Services Committee in the Rayburn House Office Building on Capitol Hill February 27, 2018 in Washington, DC. Powell said recent market volatility will not influence Fed decision-making on raising interest rates.

It's tempting to look further afield. What about non-U.S. bonds? Risk-loving investors could look to troubled Argentina, where one-year bonds yield nearly 26 percent. Those looking to play it a little safer might try India, where many government bonds yield more than 6 percent. That's a lot better than rates in the United States, where 10-year Treasurys are rising but still pay less than 3 percent. In Europe some bonds sport negative yields. Generally, it's the less-developed countries that pay the most, with fat yields offered from Egypt and Indonesia to Kenya, Nigeria and Malaysia.

But investing experts remain divided over "reaching for yield" too hard, as big yields usually mean big risks. Also, a strengthening world economy causes central banks in developed economies to wind down the stimulus programs they've been employing for years, threatening bond prices.

"When we look around the world, we see a synchronized global economic expansion," said Clem Miller, portfolio manager for Wilmington Trust Investment Advisors. "We are currently advising our clients not to invest in non-U.S. fixed income," Miller said, warning that risks in the developed countries could have ripple effects harming bonds elsewhere. "We think that there is a likelihood that the European Central Bank will slow down or even terminate the bond purchase program, which will lead to higher intermediate-term yields." The Bank of Japan may do the same, he added.

Top 5 most-popular bond ETFs in 2018

ETF
YTD flows
1-year flows
Ticker
iShares Core US Aggregate $3.45B $13.96B AGG
Vanguard Total International Bond $1.64B $4.23B BNDX
iShares Short Treasury Bond $1.48B $5.05B SHV
iShares TIPS Bond $1.17B $2.76B TIP
VanEck Vectors JP Morgan EM Local Currency Bond $1.11B $2.94B EMLC
XTF.com, data through Feb. 26

Some investing experts continue to be positive on select opportunities in bond markets across the globe, even with the outlook for many big bond markets muted.

Hosein Maleki, assistant professor of finance at Temple University's Fox School of Business, expects inflation to rise above 2 percent in the United States in the next few months, causing the Fed to nudge up yields and reducing the extra yield premium investors get for tying money up in longer-term bonds. In his first testimony on Capitol Hill, new Fed Chairman Jerome Powell spoke in hawkish tones that lead many market watchers to expect as many as four interest-rate hikes this year.

"In the next 12 months, I expect the U.S. and Canadian bond yields to increase, Japan and East Asia to remain flat or increase only slightly, and Latin American bonds to remain flat, as well," Maleki said.

Among the developed fixed-income markets, Maleki is positive on Japan. "Japan is one of the most interesting alternatives" to U.S. bonds, he said. "As the fourth-largest global economy, Japan is experiencing a prolonged economic expansion that is considered the second largest since WWII. It is, therefore, unlikely for the Bank of Japan to alter the relaxed monetary policies already in place."

Recently, the Bank of Japan announced unlimited bond buying to push up the prices and keep the yields low. "The Japanese bond market remains attractive, at least in the short run," Maleki said.

Emerging markets are attractive, but risks are high

A good alternative to U.S. bonds and developed markets overseas may be some of the emerging markets, such as India, Saudi Arabia and Turkey, said Ketaki Sharma, founder and CEO of Algorithm Research in the United Arab Emirates, citing government bonds. Some A-rated Saudi bonds, for instance, yield more than 3 percent, though she said they are riskier than U.S. Treasurys, which have been rising and which are expected to continue to see higher yields.

Some sound Indian government bonds also beat 3 percent and will look less risky as the country's economy strengthens, Sharma said. Bonds that look attractive but are rated below investment grade include issues in Turkey and South Africa. "For similarly rated sovereigns, we think Turkish sovereign debt yielding over 4 percent is probably the most attractive bond."

Teresa Kong, head of fixed income at Matthews International Capital Management, a firm managing $36.4 billion in assets and focused on the Asian markets, favors Asian corporate bonds. "In simple terms, Asia high-yield bonds are compensating investors for taking credit risk, in our view, while U.S. and European high-yield bonds are not," Kong wrote in a recent analysis.

Top international bond ETF returns, 1-year

ETF
1-year performance
YTD performance
Ticker
PowerShares International Corporate Bond 13.82% 1.11% PICB
iShares International Treasury Bond 12.70% 2.42% IGOV
iShares 1-3 International Treasury Bond 11.35% 2.92% ISHG
SPDR Barclays International Treasury Bond 11.04% 2.71% BWX
SPDR Barclays Capital Short Term International Treasury Bond 10.69% 3.00% BWZ
SPDR Citi International Government Inflation Protected Bond 10.65% 3.02% WIP
VanEck Vectors International High Yield Bond 9.19% 0.67% IHY
XTF.com, data through Feb. 26

Some Asian bonds start with a 4 percent yield but could pay even more if Asian currencies continue to strengthen against other currencies as they did in 2017, Kong wrote. She expects solid mid-single-digit returns for many Asian currencies. That may present a currency arbitrage opportunity to investors equipped to buy individual foreign bonds, but most U.S.-based investors and financial advisors are much more likely to use bond mutual funds and ETFs. There are now competing international and emerging markets bond ETFs denominated in USD and local currency.

Bonds issued outside the United States entail some risks that investors in the United States and elsewhere are wise to keep in mind. Financial reporting requirements are not as rigorous in many countries as in the States. Political and economic instability can quickly roil foreign markets. And profits won in one country can turn into losses when winnings are converted to the investor's home currency.

Many experts argue that, wherever they look, bond investors should emphasize issues with solid credit quality and shorter duration, a figure expressed in years that indicates how much a bond's value could change as yields rise or fall — a 5 percent loss for a five-year duration if rates rise 1 percentage point, for instance. Bonds with shorter maturity and duration are less volatile when rates change, because investors don't feel the effects for as long.

"We would be shorter on duration and higher in (credit) quality at this point in the cycle," said Chris Wolfe, chief investment officer of First Republic Private Wealth Management in northern California. Investors in U.S. bonds would be wise to limit durations to between three and five years, he said.

But that's not good enough for advisors who insist investors are better off reducing overall bond exposure in the current environment. Allowing yields to rise on new bonds could draw investors out of older, stingier ones, pushing down bond prices. With bonds facing this risk in much of the world and with corporate earnings on the rise, Wilmington Trust Investment Advisors' Miller said stocks remain the safer bet for investors focused on overall return. Dividends are likely to rise, too, he said, making stocks a good option for income-seeking investors as well as those looking for growth. These factors argue for reducing bond allocations in favor of stocks.

By Jeff Brown, special to CNBC.com

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