Protecting Your Bond Portfolio

06/20/2003 12:00 am EST


"With interest rates scraping bottom, the question is no longer if they will rise, but when," says Marla Brill in the June 2003 Financial Advisor. The magazine also operates as a means of matching individual investors with investment advisors who meets their specific needs. Here, the magazine outlines alternatives for fixed-income investors and suggests a variety of means to protect one's principal.

"A return to the double-digit bond yields of the 1980s appears unlikely. But there are some signs pointing to an upswing in interest rates in the next year or two. Treasury bonds could come under pressure later this year as the budget deficit forces the federal government to issue more securities. And bond prices have trounced stocks by such a wide margin, that the potential for price deterioration far exceeds the possibility of further gains. In this unsettled environment, financial advisors face the dilemma of putting fixed-income allocations to work, or protecting current positions, at a time when the three-year old bond market bubble could pop. The prospect of falling bond prices has some advisors re-thinking old strategies and paying more attention to a side of the portfolio that once required minimal maintenance.

‘We haven’t faced this kind of interest-rate environment in quite awhile, and some have never faced it at all,’ says Jeff Street , a CFP with Street Financial Services. ‘Investment in bonds can no longer be an afterthought to the stock market. We need to have keener, more thoughtful strategies in place to protect clients.’ With money market rates still well below 1%, letting fixed-income allocations sit on the sidelines isn’t an option. From shortening maturities, to increasing their use of dividend-paying stocks, to exploring new types of securities, financial advisors are drawing on a variety of investment strategies to do battle with the interest rate beast. Street has already relied on mutual funds for his fixed-income allocations. Now, he’s adding unit investment trusts and individual bonds to the mix for those who want the assurance that they will receive their principal at maturity, regardless of what happens to interest rates. ‘It used to be a no-brainer to just let the fund manager do all the work, he says, But even the best manager will have a hard time protecting principal if rates go up.’

"Bradley Teets, a CPA and CFP, says his preference for individual bonds over bond funds has grown stronger as the prospect of rising interest rates increases the possibility that bond fund investors coming into the market could suffer a setback. He typically creates a laddered-maturity portfolio for those with bond portfolios of $100,000 or more. ‘If you invest less than $20,000 per bond, the bid-ask spread on corporate issues just becomes too high,’ he says. ‘I also stick with new issues because they are simpler to buy. And because many older bonds sell at a premium now, investors would get back less at maturity than what they paid on the secondary market.’ Teets recently assembled a laddered portfolio for a retiree that incorporates a diverse range of maturities and credit qualities. The shortest run on the ladder is a one-year certificate of deposit yielding 1.65%. and the portfolio has at least one bond maturing each year over an 11-year period. It contains a mix of investment grade corporate notes and government agency issues, as well as BBB-rated notes from General Motors Acceptance Corp. (GMAC), yielding 6.15%

"Other advisors are using bonds with creative structures, including those designed to withstand a rising interest rate environment. Alex Sugar of Bear Stearns, taps the government agency issue market with ‘step bonds’ which change their interest payments in several stages. He recently purchased a step bond for a client issued by the Federal Home Loan Bank which matures in 2010. During the first two years, the bond pays a 3% rate of interest. The rate goes up to 5% during the next three years, and rises to 7% until maturity. Although the bonds are callable, that issuer protection probably won’t kick in unless rates fall below what the bonds are paying. Sugar also buys floating-rate bonds, or ‘floaters. The rate on these corporate issues, which is usually pegged to the LIBOR or Treasury bills, changes periodically. For older, retired clients, he often recommends intermediate-term corporate notes that give heirs the option to ‘put’ the note back to the issue at par plus accrued interest when the original owner dies, even if interest rates have risen since the purchase date. Although both types of securities offer protection against increases in rates, their yields are usually slightly lower than fixed-income securities of the same quality and maturing.

"Meanwhile, some sectors of the bond market have historically been less sensitive to rising interest rates than others. Government agency bonds such as GNMAs, for example, tend to feel less of a pinch from rising interest rates than Treasury bonds or high-quality corporate issues. When interest rates rise, the combination of high yield and lower prepayment risk makes them more attractive to investors says Dan Wiener, editor of the Independent Advisor for Vanguard Investors. He points out that between July 1999 and January 2001, a time of rising interest rates, the return of the group’s GNMA funds surpassed that of almost all of Vanguard’s other income portfolios. Another buy on Wiener’s list is the group’s high-yield corporate bond fund. Wiener believes that high-yield bonds were oversold last year and the focus on improving credit quality should help overshadow the possible impact of rising interest rates. Others are simply cutting bond allocations and shortening maturities. Scott Kays, a CFP with Kays Financial Advisory, has gradually been decreasing the bonds inside his portfolio of the last few years. He recommends a 40% allocation for conservative investors, 20% for moderate investors, and zero bonds for aggressive investors. He has moved more fixed-income assets into short-duration bond funds, such as PIMCO Low Duration (PTLAX) and PIMCO Total Return (TARBX). Using a combination of these funds, his fixed income portfolios achieve a duration of about three years.

"Finally, to hedge long-term bond positions, Jeff Street uses the ProFunds Rising Rates Opportunity Fund (RRPIX), which is designed to track 125% of the inverse daily price movement of long-term Treasury bonds. If the yield on 30-year Treasury bonds rise and their prices fall by 1%, the fund’s net asset value should increase by 1.25%. Of course, the fund’s net asset value falls in the same proportion when bond prices rise. A fund with a similar objective, Rydex Juno (RYJUX), uses options and future to provide total returns that inversely correlate to the daily price movements of the 30-year Treasury bond. Both funds can be used by hedgers like Street who want to protect long-term bond holdings, or by speculators who want to profit from rising interest rates."

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