Individual bonds can help protect income
The Federal Reserve's QE2 strategy, lowering longer-term interest rates at a time when shorter-term rates are already near 0%, creates an impending conundrum for bond investors: what to do now that interest rates either have hit bottom or will remain low for a prolonged time.
The Federal Reserve’s QE2 strategy, lowering longer-term interest rates at a time when shorter-term rates are already near 0%, creates an impending conundrum for bond investors: what to do now that interest rates either have hit bottom or will remain low for a prolonged time. Gone are the days when investors can rely on falling rates to drive total returns.
Since 1981, falling rates have provided a tremendous tail wind. The 10-year Treasury bond index has witnessed a spectacular average total return of 11.3% since interest rates peaked in 1981 and began their 30-year period of decline. That is in stark contrast to the prior 30-year period’s average total return of only 2.2%.
Now bond investors are facing an inflection point that will require a significant change in strategy, particularly if they are looking to draw retirement income out of their portfolios in the next few years. If rates indeed have reached bottom and begin to rise in 2011, protecting portfolio cash flows against falling bond prices will be central to successful strategies. Even if rates stay flat, the focus of bond portfolios will have to shift to the production of reliable income and the protection of principal rather than focusing on total return.
One way this can be done is to utilize individual bond strategies rather than bond funds. If investors hold individual bonds to maturity, they will receive both the intervening coupon payments and the bond’s redemption value at maturity, unaffected by changes in the underlying value of the bond. That advantage is what makes individual bonds unique.
CONVENTIONAL WISDOM
In a rising-interest-rate environment, the conventional wisdom for bond fund investors has been to find funds with shorter durations in order to lessen potential losses. But if rates don’t rise and we enter a period of sustained, flat interest rates such as experienced by Japan over the last 20 years, investors will need longer durations to improve returns.
In other words, there is a significant opportunity cost to keeping durations short if rates stay flat at their near-zero levels and fixed-income allocations earn practically nothing. Yet if rates rise, funds of longer-duration bonds are subject to greater losses.
This is because of the inverse relationship between current rates and bond values. The general rule of thumb is if rates rise by 1%, the bonds in the portfolio will lose a percent value equal to their duration. If the price loss outweighs the coupon income, a bond fund will have negative returns.
To avoid this Catch-22, retirees and investors approaching retirement can use individual bonds to create an income-matching portfolio and thereby protect the portfolio cash flows that will replace their paychecks. Based on the simple concept of a bond ladder, income-matching portfolios synchronize coupon and redemption payments to match the target income stream precisely. These portfolios protect the cash flows from falling bond prices caused by rising interest rates. That is, the value of the portfolio is not immunized; the cash flows themselves are immunized. The internal rate of return of the portfolio becomes the minimum return, regardless of changes in rates.
Bond funds cannot immunize cash flows, because they turn over their portfolio holdings instead of holding their bonds to maturity. Only a portfolio of individual bonds, held to maturity, can protect cash flows from rising rates.
In terms of asset allocation, there would be no difference in terms of fixed income whether held as individual bonds or bond funds. For example, if a retiree holds 40% in bond funds simply to reduce volatility, that same allocation could be reinvested in individual bonds calibrated to supply predictable cash flows matched to the investor’s income needs. The allocation to fixed income stays the same but now serves a dual purpose — it continues to provide stability but also provides a protected cash flow.
Brent Burns is the president of Asset Dedication LLC, a separate-account manager specializing in pension-fund-style investing for individuals.
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