Stocks & Bonds


Turbulent Days Ahead for Bond Investors

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Remember the early 1980s, when Pac-Man and MTV were brand new? That era also marked the birth of a bond-market bull run—a three-decade stretch of strong performance that taught a generation of investors to rely on bonds for steady income and portfolio stability.

See Also: Protect Your Portfolio Gains From a Market Dip

Fade out the flashy Michael Jackson video. Much darker days are ahead for the bond market, fixed-income experts say, and they'll pose particular challenges for older investors relying on bonds to cover expenses.

Yes, it's "bad," and not in that cool King-of-Pop way. Bond investors are facing rock-bottom yields, the threat of rising interest rates (which mean falling bond prices), longer-term inflation and the ongoing European debt crisis. Professional investors and advisers don't express unmitigated enthusiasm for any segment of the bond market. Low yields on many of the safest bonds virtually guarantee that investors will lose money, after inflation, and yields on more-exotic debt generally aren't high enough to compensate investors for their additional risks.

Yet bonds remain a valuable source of income and portfolio diversification—and an essential part of most older investors' portfolios. When U.S. stocks post steep declines, Treasuries and investment-grade corporate bonds tend to notch modest gains, cushioning the blow for balanced portfolios. And investors can tweak their fixed-income portfolios to safeguard against some of the biggest bond-market risks, such as rising interest rates, while accepting some of the smaller risks, such as sluggish returns that won't always keep pace with inflation.

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Thanks to the Federal Reserve's unprecedented efforts to strengthen the economic recovery by keeping rates low, bond investors are navigating uncharted territory. The Fed said in early May that it would keep its short-term interest-rate target at 0% to 0.25% and continue buying bonds at a pace of $85 billion a month—an effort aimed at driving down longer-term rates. "This is very unlike any market we've seen before, because the starting level of interest rates is so low," says Mark Egan, lead manager for Scout Funds' fixed-income portfolios. With bond yields offering investors so little cushion against losses, he says, "you don't need to have this idea that inflation will rage or interest rates explode to be very fearful of the bond market."

Indeed, most market watchers expect a gradual increase in interest rates, not a big spike, but even modest moves could trigger losses in bond portfolios.

Although inflation currently looks modest—1.5% for the 12 months ending in March—it's already higher than the yields on many "safe" bonds. And advisers see inflation picking up longer term as the Fed and other nations' central banks seek to jump-start economic growth with easy-money policies.

Advisers also fear that investors, who poured money into bonds in recent years, are unprepared for the bad times ahead—and will rush for the exits at the first sign of trouble. The Fed may signal a gradual withdrawal of its stimulus, "and everyone will interpret that as, 'I gotta get out of here,' " says Hugh Lamle, president of M.D. Sass, a New York investment-management firm. The stampede "can get a little bit panicky."

As the risks pile up, some retirees are avoiding bonds entirely. Gene Dettman, 63, dumped almost all of his bond holdings early last year, largely because of his concern about rising interest rates. Dettman, who retired from the information technology industry eight years ago and lives outside of Abilene, Tex., generally keeps six to 12 months' worth of living expenses in a bank savings account and periodically refills this cash bucket using stock dividends or by taking gains from his stock portfolio. His bond allocation, he says, is just 0.3%, invested in an intermediate-term bond exchange-traded fund. He plans to reevaluate his bond holdings after rates rise, but "they hit me right now as being a losing asset going forward," he says.

While many retirees may share Dettman's dim view of fixed income, dumping bonds completely probably isn't their best course. Here's how to recalibrate your bond portfolio for an era of heightened risk.

Dial Down Risk of Core Holdings

U.S. Treasuries and investment-grade corporate and municipal bonds form the bedrock of many retirees' portfolios. They're also expensive because many investors have stuck to these plain-vanilla holdings even as the Fed's bond purchases helped drive valuations higher. Now, several adjustments are needed to rein in the risk of these core holdings.

One major change: Advisers are reducing allocations to core bond holdings, shifting money into other fixed-income sectors. Litman Gregory Asset Management, for example, has slashed core bond holdings in its most conservative portfolios to roughly 20% of the total bond allocation, down from 70% or 80% several years ago, says Chris Wheaton, managing partner at the Larkspur, Cal., investment-management firm. The firm has shifted some money from core bond holdings to "unconstrained" bond funds that can invest anywhere in the bond market.

Advisers are also lightening up on any longer-term bonds, which are most vulnerable to rising rates. Many aim to keep "duration," a measure of interest-rate sensitivity, under five years—a bit shorter than the Barclays U.S. Aggregate Bond Index, a broad benchmark for core bond holdings. Generally speaking, for each 1% increase in interest rates, a bond's price will fall 1% for every year of duration. Check your bond fund's average duration by typing in the fund's name or ticker symbol at Morningstar.com and clicking the "portfolio" tab.

Despite longer-term concerns about inflation, many advisers are also avoiding Treasury inflation-protected securities. TIPS, whose principal is adjusted to keep pace with inflation, are currently offering negative yields on maturities up to ten years. For protection against inflation, "we'd rather be in commodities and other real assets," says John Workman, chief investment strategist at Convergent Wealth Advisors. Investors already holding TIPS or TIPS funds might consider taking some profits but maintaining a moderate long-term allocation to these bonds—since inflation is likely to be a bigger factor down the road.

Many fund managers say they're still finding value in mortgage-backed securities—both "agency" MBS issued by government-sponsored enterprises, such as Fannie Mae or Freddie Mac, and non-agency MBS issued by banks and other private lenders. Bond funds with a strong track record investing in mortgages include TCW Total Return Bond (TGLMX) and DoubleLine Total Return Bond (DLTNX).

Choosing Core Bond Funds

When choosing plain-vanilla bond funds, remember that many core-fund managers have wandered well outside their traditional boundaries, dipping into riskier high-yield "junk" bonds, emerging-markets debt and other holdings (see Seeking Yield, Bond Funds Ramp Up Risk). Such funds may be a fine option, but you'll want to avoid loading up on those riskier sectors elsewhere in your portfolio. Keep tabs on the funds' quarterly disclosure of portfolio holdings, found on fund companies' Web sites, and check the fund's "portfolio" page on Morningstar.com to compare its credit quality and sector weightings against its peers.

Because fund expenses reduce your returns, insisting on low fees is "the easiest and quickest way to increase your income," says Kent Grealish, partner at investment advisory firm Quacera, in San Bruno, Cal. He likes Vanguard Intermediate-Term Investment-Grade (VFICX), which focuses on high-quality corporate bonds and charges 0.2% annually, versus 0.9% for the average intermediate-term bond fund.

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