Investors have long considered bonds the safe, even dull, part of portfolios. Not anymore.
With interest rates likely to continue rising from their historic lows, investors are rightfully concerned about the prospect of a prolonged bond bear market. Yet many financial advisors caution against bailing out of bonds entirely, despite the drubbing the fixed-income market took last year.
In a rising-rate environment, many investors are dialing up their exposure to equities. But advisors say that bonds still represent the best way for most investors to offset potential stock market losses and that there are a variety of fixed-income strategies that can mitigate the risk of rising rates. Interest rates and the prices of bonds generally move in opposite directions.
“Last year we saw the stock market surge and most fixed-income investments suffer low, single-digit percentage declines,” said Jenifer Aronson, a chartered financial analyst and managing partner at fee-only registered investment advisor Mosaic Fl. “That is the way diversification is supposed to work. As a portfolio manager, I can’t ask for much more than that.”
Long-term bond portfolios tend to be highly sensitive to changes in interest rates, so many advisors are looking to short- and/or intermediate-term bond funds. Among short-term bond funds, some financial planners like those investing in high-quality, floating-rate corporate bonds. Floating-rate bonds (also known as floaters) tend to be less volatile than fixed-rate bonds because their interest payments reset periodically, based on a benchmark or reference rate.
“You probably don’t want to be invested in long-term bonds when rates are rising, because you are courting more interest-rate risk there,” said Daniel Sands, a certified financial planner and managing principal at Silversage Advisors.
“The common measure to look at is duration. You need to consider the duration of each of the bond funds in your portfolio,” he said. “The longer the duration, the more interest-rate sensitive the portfolio will be.”
(Read more: Buckle up for a likely bond-rate bump)
Investors who don’t have the stomach for losses in principal might consider buying individual, high-quality government or corporate bonds and holding them to maturity. That strategy provides more certainty than investing in bond funds but may also have “opportunity costs,” according to Christine Benz, director of personal finance for research firm Morningstar.
“By locking in today’s relatively low rates,” wrote Benz, “the individual-bond investor who’s buying and holding won’t have the opportunity to swap into higher-yielding bonds if and when yields pop up.”
Bond ladders a better bet?
For clients who crave certainty that they will have the cash to meet an upcoming financial need, some advisors are setting up so-called bond ladders, which are portfolios of bonds maturing at different times. A ladder might contain equal amounts of bonds with maturities of two, four, six, eight and 10 years. Investors can take out the proceeds from maturing bonds or, if rates rise, reinvest that money at higher rates.
“We look at laddering as a way for someone to match a financial need rather than a portfolio management strategy for total return,” said Gary Ribe, director of research and investment management for MACRO Consulting Group. “Laddering is a way of dealing with uncertainty and appeals to clients at or near retirement age looking to manage their cash-flow stream.”
(Read more: Ready to bail on bonds? Not so fast)
Given the uncertain outlook for interest rates, many investors are also venturing into more credit-sensitive types of bonds. Credit-sensitive bonds, which include so-called junk bonds, generally offer fatter yields than higher-quality, fixed-income investments, providing a cushion in a period of rising rates.
Credit risk, which differs from interest-rate risk, pertains to the chances that a bond’s issuer will not make scheduled interest and/or principal payments.
“With convertibles … there is admittedly some risk, but not the same risk as a traditional stock or bond.”-Dave Demming, president, Demming Financial Services
With economic conditions improving, many investors aren’t worried about widespread defaults. Yet advisors caution against ramping up risk on the fixed-income side of portfolios in a quest for yield. Certified financial planner Dave Demming, president of Demming Financial Services, said the spread on junk bonds (or the yield difference between such bonds and comparable higher-quality corporate or government bonds) has narrowed considerably in recent years.
Given today’s low spreads, he believes investors aren’t being paid enough for the risks they are taking in the junk bond market.
“People are chasing yield and setting themselves up for disappointment,” he said.
(Read more: Bond outlook dim, investors turn to alternatives)
Rather than chase yield, Demming says most investors would do well to include convertibles in their bond portfolios. Convertible bonds typically pay lower coupons (or interest rates) than standard bonds but give investors the option to convert their holdings to common stock if a company does well.
“With convertibles, you are going to have some downside protection as well as potential upside participation,” he said. “There is admittedly some risk, but not the same risk as a traditional stock or bond.”
Indeed, no strategy is without potential pitfalls. Hunkering down in short-term bonds might seem like a “no-brainer,” noted Benz of Morningstar, but investors who follow that path might be sacrificing returns. Despite the nervousness surrounding interest rates three years ago, the typical intermediate-term bond fund has gained nearly 2 percentage points more, on an annualized basis, than the average short-term bond fund since 2011, according to Morningstar.
While rising rates are a legitimate concern, advisors say investors should keep things in perspective. It’s true that inflation can lead to higher interest rates and erode the purchasing power of bond investors’ future cash flows, but inflation, they say, isn’t much of a threat, given the lingering softness in the labor market and constrained bank lending.
(Read more: Stocks still tops, advisor survey finds)
“A real risk in the fixed-income markets is inflation rearing its ugly head, and there are no indicators that this is going to be an issue in the near term,” said Aronson of Mosaic FI.
Demming said investors need to reset their expectations and accept the probability of lower returns in the fixed-income arena. Over the last 20 years, bonds have provided a 6 percent annual return, he noted, adding that given current low yields and the rising-rate environment, investors shouldn’t expect a repeat performance.
“Five years ago you could put your money anywhere and make easy money,” he said. “Today we have to roll up our sleeves and be more selective. But your returns are probably going to be lower, and you just have to accept it.”
—By Anna Robaton, Special to CNBC.com