NEW YORK (CNN/Money) -
My investment adviser keeps postponing putting a portion of my portfolio into bonds, claiming it's not a wise thing to do in a rising interest rate environment. Everything I read, however, tells me that as a retiree I should have a bond allocation of at least 40 percent. What should I do now to achieve a more balanced investment risk profile?
-- Jay Headley, Wilmington, Delaware
I'm amazed at how many people think they can predict the future of interest rates when, in reality, there's so little evidence that anyone's any good at it.
Take this year, for example. Back in the first quarter of the year when 10-year Treasury yields were hovering around 4 percent, bond market pundits everywhere were so certain rates were headed toward ever higher ground that a bloodbath in the bond market was considered a virtual certainty.
So what happened? Rates did rise to about 4.8 percent by June -- and then promptly fell back to around 4 percent, which is where they've been lately.
And if investment pros know so much about what rates are going to do, why weren't they advising us to invest in bonds back in January 2000, when the 10-year Treasury was yielding a nice 6.8 percent.
But noooooo, they were so sure stocks were the place to be that bonds were virtually ignored. So pardon me, but I can't get too excited about predictions about where rates are headed.
Timing doesn't work
Don't get me wrong. I understand why investors are jittery about going into bonds now. I feel the same way. Interest rates are still fairly close to historic lows.
And unless you see the economy going into the toilet -- which I don't -- it would seem more likely that rates would rise rather than decline from here.
But that still leaves the matters of timing and degree -- when would rates rise and by how much? The "when" issue is anyone's guess. As for how much, well, recent trends in inflation certainly don't suggest that a big bump in rates is in the offing.
But who knows? My guess would be that rates will climb over the next year or so, perhaps by one percentage point or so. But the truth is that neither I nor anyone else has a clue.
Your investment strategy
So how does all that translate into a bond investing strategy for a retiree like yourself (or anyone else, for that matter)? Well, I certainly don't think it means you avoid bonds, or wait for some sign to go into them (what would that sign be?).
Are you supposed to keep your entire portfolio in stocks while you're waiting? That seems risky. Or are you supposed to keep it all in cash? Not much of a return there while you're waiting -- and you still get back to the question of how do you know when to move into bonds.
In the face of such uncertainty, I think a savvy investor's first defense is diversification: hold some stocks and bonds. The second line of defense lies with what kind of bonds you hold. I'd stick with short and intermediate-term issues -- maturities of, say, two to seven years.
Why? Two reasons. First, you pick up much of the yield of longer-term issues by staying in short and intermediate issues. That's important because over time the overwhelming majority of a bond's return comes from its yield, or interest payments, not price appreciation.
The other reason to stay in short and intermediate issues is that they're a lot less volatile than long-term issues. So you're getting the bulk of the return with a lot less risk.
I'd also diversify my bond holdings broadly. I'd throw in some high-grade corporates for the extra yield they offer and I'd even throw in a smidgen of high-yield bonds. That's right, junk bonds, because their higher yields offer a bit more protection from rising rates than Treasuries and investment-grade bonds.
Depending on my tax rate, I'd also consider munis (unless I was holding these bonds in a tax-advantaged account.) And to make this easier on myself, I'd probably buy low-cost bond funds rather than individual bonds.
Rising rate are not always bad
One final note. While bond investors get panicky at the thought of rising rates, the fact is that a move to higher rates can actually help bond-fund investors who are investing for the long term.
Yes, a bond fund's value will take a hit immediately after rates rise. But the manager then gets to invest the interest payments from bonds in the portfolio as well as any principal repayments into new bonds paying the higher rates.
The result is that over time the bond fund will have a higher return than if rates had remained the same or fallen. I should caution that investors will be no better off (and could be worse off) if all of the higher return merely reflects higher inflation. But that's usually not the case. For more on how interest rate changes affect a bond fund's return, click here.
Bottom line: we just don't know when rates will move and how high or low they'll go. Rather than try to time moves in and out of the bond market, I think it makes more sense to maintain an overall stocks-bonds asset allocation mix, and then take reasonable steps in your bond portfolio that will give you a shot at decent long-term returns without taking unreasonable risks.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."
|