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How to build a better bond portfolio: 3 advisors' takes

  • How much of the bond landscape you want to sample is a matter of personal inclination and tolerance for risk.
  • Some financial advisors keep their clients' bond portfolios "simple" and/or "boring."
  • Barry Glassman of Glassman Wealth Services points to three approaches to bond investments: traditional, tactical and diversified.
Bonds
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For the majority of Americans, stocks and bonds represent the two asset classes anchoring an investment portfolio. There is also real estate, perhaps some alternative investing and maybe collectible items that carry significant value. But at the end of the day, the performance of stocks and bonds will drive the overall wealth of investors in the financial markets.

The bond markets are vast and diverse, encompassing everything from risk-free Treasury bonds and tax-advantaged municipal bonds to investment-grade corporate debt and riskier, high-yield and emerging market bonds.

Just how much of the bond landscape you want to sample is a matter of personal inclination and tolerance for risk. The range of opinion in the financial advisor community on the role of fixed-income investments and how to effectively construct bond portfolios is similarly diverse.

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Some primarily use bonds to balance the risks they take in the stock market. They want no surprises from their bond allocations, so they stick with Treasurys and investment-grade bonds. Others take a more expansive view of the bond markets and are willing to take on risk to find more return from fixed-income holdings.

Virtually all financial advisors, however, consider bonds an essential part of any diversified investment portfolio.

CNBC spoke to three advisors about how they use bonds in their client portfolios.

Brian Haywood
Investment strategy advisor, Buckingham Strategic Wealth and BAM Advisor Service
Brian Haywood likes to keep his investments in bonds simple. "We think of fixed income as the bedrock of a client's portfolio," he said. "It is there to preserve and protect wealth as opposed to growing it."

Brian Haywood
Jerry Naunheim Jr.
Brian Haywood

With that in mind, he limits his investments in bonds to Treasurys and investment-grade debt. He doesn't even consider high-risk junk bonds or emerging markets debt despite their significantly higher yields.

"The further you go out on the yield curve or down the credit-quality spectrum, the more you lose the diversification benefits of bonds vs. stocks," he explained. "If the bonds you buy have a high correlation with stocks, it defeats the purpose of the investment."

In the last 10 years of very low interest rates, plenty of clients have been asking BAM advisors about the higher returns they could be getting in junk bonds or emerging markets debt. "We try to talk them out of it," said Haywood. "We urge them to stay in high-quality bonds.

"There is no evidence that high-yield or emerging markets debt provides better risk-adjusted returns."

"We think individual bonds are a more efficient way to get exposure." -Brian Haywood, investment strategy advisor for Buckingham Strategic Wealth and BAM Advisor Service

The one area where Haywood is somewhat tactical is in the management of the duration of bond holdings. He usually keeps it within a range of three to five years. When the yield curve is steep (long-term rates are significantly higher than short-term), he tilts portfolios to the longer end of his range. When it is flatter, as it is today (the spread between the two-year and 10-year Treasury bonds is about 50 basis points), he positions clients on the shorter end.

Haywood prefers to buy individual bonds as opposed to bond funds if clients have enough assets. His rule of thumb is that clients need about $1 million in their fixed-income allocations to warrant constructing a bond ladder of individual securities.

A bond ladder buys multiple bonds of different durations. As one bond matures, you reinvest the principal in a new bond.

"We think individual bonds are a more efficient way to get exposure," he said. It also enables him to tailor the ladder to each client's financial needs. "You can customize a ladder to each client in terms of their cash flow needs or even their state of residence."

Mark Cortazzo
Senior partner, MACRO Consulting Group
Mark Cortazzo doesn't want his clients' bond holdings to keep them up at night. "Fixed income should be boring," he said. "What I hope for most is no surprise, because surprises with bonds are almost always bad."

Mark Cortazzo
Mark Cortazzo

That doesn't mean he only invests in high-quality bonds. After all, in the last 10 years of financial repression by the Federal Reserve Bank, real returns on high-quality investment-grade debt have been lousy. "If you've been in short-term high-quality paper for the last 10 years, you haven't kept pace with inflation," said Cortazzo.

What matters most are a client's financial objectives. What are their retirement income needs? How much do they want to leave their family? Do they want to give to charity? What bonds to buy depends more on those needs than on market conditions.

"People need to understand what they're trying to accomplish with fixed income," Cortazzo said. "I might build a 10-year bond ladder for someone who needs income between 65 and 75 years old so they can defer [and increase] their Social Security benefits.

"For that, you need to use high-quality bonds that provide the income stream and return your principal."

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Cortazzo also appreciates the value of bond investments that don't correlate with equity risk. That doesn't, however, preclude him looking at more risky bond sectors, such as high-yield and emerging markets debt, despite their strong correlations to stocks in bad markets.

"If the purpose of owning bonds is to mitigate the risks of U.S. equities, then [high-yield and emerging markets] won't help in a down market," he said. "But there are plenty of times when high-yield or emerging markets have done well when stocks haven't."

Given the extremely low yields over the past decade, he believes it's worth considering higher-risk/-reward investments. "I don't disagree with the idea of taking most of your risks in the stock market, but bonds aren't paying much, so all your gains are being driven by stocks," he said. "I want something else that contributes."

With that said, he does not think the returns are currently enough to warrant taking the risk. With credit spreads still tighter than historical averages, investors could get burned reaching for yield.

"People could be picking up pennies in front of the steamroller," said Cortazzo. "High-yield and emerging markets debt hasn't gotten really whacked in a while."

Barry Glassman
President, Glassman Wealth Services
There are three approaches to investing in fixed income, suggests Barry Glassman, head of Glassman Wealth Services. "There is a traditional, tactical or diversified approach," he said. "I've chosen to be less tactical as time goes by."

Barry Glassman, CNBC Financial Advisory Board
Barry Glassman, CNBC Financial Advisory Board

With the traditional approach, the purpose of bonds is to invest in high-quality securities that reduce volatility and enable investors to count on an income stream and the return of their principal investment. "Some financial advisors believe that's the sole purpose of fixed income," said Glassman. "They may go out the yield curve [on duration], but they don't reduce credit quality."

Advisors who take a tactical approach are willing to venture into higher risk bond market segments and look for triggers to buy and sell positions. Typically, those triggers involve spreads relative to their historical average. For example, the current spread of high-yield bonds to comparable duration Treasury bonds (as measured by the Bank of America Merrill Lynch US High Yield Master II index) is 3.55 percent as of June 1. That's up from a 10-year low of 3.23 percent on Jan. 26 but still well below historical averages.

Glassman suggests that timing the bond market is no easier than the stock market and that investors have not fared well trying to be tactical. "Investors have a bad track record timing their purchases and sales of bond market sectors," he said.

"Most people are surprised that the two-year Treasury yield is now at 2.5 percent. Even if an advisor is not tactical, they have to consider what happens if safe yields move even higher. At what rate will you lock in better returns for a longer period?" -Barry Glassman, president of Glassman Wealth Services

Glassman prefers to take a diversified approach to investing in bonds. He builds a core portfolio of high-quality Treasurys, municipal bonds and investment-grade debt and augments that with noncore holdings of bond funds, where he gives more latitude to fund managers to invest. He does not use indexed bond funds.

A risk to monitor if you invest in multiple bond funds with wide manager discretion, however, is that they aren't all investing in the same assets. "Investors need to understand what a manager's strategy is at any given time," said Glassman. "You want to try and pair up sectors and strategies that differ."

Glassman expects the yield drought of the last 10 years to continue for an extended period. "Baby boomers' hunger for yield will keep risk-free yields low for a long time," he said. With that in mind, the recent rise in rates poses a challenge for advisors and investors in terms of the duration of their fixed income investments.

"Most people are surprised that the two-year Treasury yield is now at 2.5 percent," said Glassman. "Even if an advisor is not tactical, they have to consider what happens if safe yields move even higher.

"At what rate will you lock in better returns for a longer period?"

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