Vanguard Total Bond Market Index ETF (BND) is down near-5 percent this year. Vanguard's Long-Term Corporate Bond Index ETF (VCLT): a whopping 11.50 percent year-to-date decline. Worse yet, neither one would've made it to "flat" this year even if you include their full-year dividends from interest.
So much for the safety and stability of bonds, right? Maybe, but maybe it isn't so wise for investors to dismiss bonds outright. With the Dow Jones Industrial Average down 600 points on Monday, 65 percent of the S&P 500 in correction (or worse) and a litany of headwinds for investors, it feels like the current bout of volatility will be with investors for a long time. A good many of my clients are either pre-retirees, new to retirement or retired for a long time already. They all want to know that they can count on a stable investment that pays enough interest to supplement or support their lifestyle throughout their retirement.
The last decade has made this task harder than ever due to the Federal Reserve's low interest-rate policy, intended to stimulate the U.S. economy enough to recover from the Great Recession. It has forced many conservative investors into stocks that pay dividends and bonds with longer maturities and/or higher credit risks. In Wall Street parlance that's called yield chasing. It works great while interest rates remain low; it destroys portfolios when interest rates go up. Adding insult to injury, without interest rates returning to post–Great Recession lows, it is hard to imagine any scenario in which investors could recover these capital losses.
Why bond diversification still matters
The global growth story that was the main narrative at the end of last year has now given way to the global slowdown as 2018 wanes. Granted, the U.S. consumer and corporate health are in great shape, but investors are now considering the fact that the slowdown signals are numerous and growing. If it is indeed the case that the global economy is on shaky ground, you'd have to consider that maybe we have seen a near term ceiling in bond yields, making it more worthwhile to include bonds as part of a diversified portfolio.
So the question becomes how to select bonds in the current environment. I don't think enough people realize this, but diversifying one's bonds is just as difficult as diversifying one's stocks. If you own Johnson & Johnson stock, then maybe your next stock purchase should be Chevron or J.P. Morgan; anything but another big drug company. It is similar with bonds. If you own a long-term (11 to 30 years until maturity) bond, then maybe your next bond should be an intermediate-term bond (5 to 10 years until maturity). Maybe you should buy a Treasury bond, one issued by the U.S government, that's guaranteed to pay interest and principal at maturity.
How duration makes bond investing harder
That all makes diversification sense, but let me introduce a word that complicates the issue: duration. Duration is a measure of a bond's sensitivity to interest-rate changes. The higher the bond's duration, the greater its sensitivity to the change.
Another, but imperfect, way to think about a bond's sensitivity to changes in interest rates is to think of longer-dated bonds as more sensitive and shorter-term bonds as less sensitive, i.e., featuring a more stable price. Other factors contribute to the volatility of bond prices, such as ratings from Standard and Poor's and Moody's Investors Service and how much interest they are supposed to pay — called the coupon.
The difficulties in diversifying bond holdings makes bond funds a good option for many, but there are a few advantages to investing in an individual bond.
For one, you know exactly how much money you'll receive at maturity. But that can be as much of a curse as it is a blessing. Think of it this way: The amount of money you receive from a bond at maturity will have less buying power in 10 or 20 years than it does now, due to inflation. Plus, if the bond trades lower between the time you bought it and the time it matures, that means you are losing money to inflation every single day that you own it. With just a 3 percent inflation rate, you'll lose half your purchasing power in about 25 years. Therefore, knowing how much you'll get back at maturity is not the end-all and be-all that people think it is.
Bond funds have advantages, too. Diversification and reinvesting of interest is simple to do. But you don't have the certainty of knowing how much money you'll receive down the road, because there is no set maturity for a traditional bond mutual fund.
Another advantage that bond funds have over investing in individual bonds is that bond funds have a way of being able to take advantage of declines in their NAV because investors can buy more shares of the fund when they reinvest at lower prices. In a down market for bonds, this would serve to lower your average cost basis.
So what's an investor to do?
3 basic strategies for bond investing
1. For individual bonds, you can ladder them.
This means buying bonds with consecutive annual maturities, i.e., maturing every year for the next five years, and when the bond that matures in one year matures, reinvest the principal into a new bond with a five-year maturity. It's a compromise that allows for adjustments to changes in interest rates and inflation, but it lowers your interest income because you didn't invest all of your funds into just the five-year bond.
2. With traditional mutual funds, you can build a diversified portfolio of bonds and maturities.
Since these bond funds won't actually have a finite maturity date, you could rebalance them periodically since their dollar amounts will fluctuate, some more than others. This way, you could stick with an appropriate risk/reward level and take advantage of price discrepancies between the bond funds.
For example, let's say an investor invests an equal amount into a money market fund yielding 2 percent and three different kinds of investment-grade bond ETFs: short-term, mid-term and long-term. Due to rising interest rates, the long- term went down 12 percent, the mid-term one went down 6 percent, and the short term one went down 2 percent, while the money market fund was up by 2 percent. Obviously, the value of all four positions has changed, which offers a chance to the investor to rebalance the bond funds back to the original allocations.
3. Newer bond ETFs offer the diversification of a bond fund with the maturity date of an individual bond.
ETF companies, including BlackRock and Invesco, have developed bond ETFs, both corporate and munis, with maturity dates. I use these to build highly diversified, laddered bond portfolios. They make this last part much easier to execute and understand. An investor can use these ETFs to build out a portfolio with consecutive annual maturities, reinvesting this year's maturing bond ETF into a new one five years out.
It's often been said that bonds are boring, but this year's declines as the Fed raises rates have made them more exciting — and frightening. But for most of my clients who invest in them, the boring nature for which bonds can usually be depended on is a good thing.
—By Mitch Goldberg, president of investment advisory firm ClientFirst Strategy