This post will cover my outlook for the various types of bonds. I tried to keep it easy to follow but I’m sure there is some fancy finance jargon, which I apologize for ahead of time. I’ll write an educational piece on how bonds work later this month (you might be surprised to find out there’s more to it than you thought).
Bonds have long been a conservative place to stash money that you want to protect. Unfortunately, as rates continue to fall, we’re running out of places to “safely” store money. This has become increasingly challenging for retirees that need income from their investment portfolios. They have been taught that as you get older, the allocation to bonds in your portfolio should increase. And why not? We’ve seen 30+ years of stellar bond returns. I think many investors are going to be highly disappointed with bond returns over the next decade though. In real terms (after inflation), they’ll be lucky to see positive returns. It’s now a game where an investor needs to choose what is most important to them – yield or stability – as the bonds with the best yields tend to be more volatile. My job is to find those areas of value where my clients will not be disappointed. So let’s take a look at some of the major bond categories.
US Government Bonds
It’s no surprise that the government has been racking up tons of debt (issuing bonds) the past few years to support the economy and prevent a recession. One of the best ways to get rid of this debt is to inflate it away. This has been the government’s favorite strategy for the past 50 years. With the choice between raising taxes, cutting spending or quietly creating inflation, I think the government will choose inflation every time.
The Fed has been purchasing billions in bonds over the past few years to push yields (interest rates) low. Real yields on the 10-year Treasury (and every maturity less than 10 years) are now negative. This means the only way to make money in Treasury Bonds is either for the economy to enter a period of recession and deflation, or for interest rates to continue to fall. I won’t rule out lower interest rates just yet, but this won’t go on forever.
I think many people have been blinded by the great returns over the past few years and are forgetting that low yields imply low future returns. At these prices/yields, I am not a big fan of Treasury Bonds. I think many investors, especially investors using mutual funds, will be very disappointed moving forward.
Municipal Bonds
There have been a lot of rumors over the past few years that a huge wave of defaults is coming through the Muni Bond market. I’m going to come right out and say that I disagree. I think it’s an overblown concern.
You have to keep in mind that nearly every entity finances its operations by borrowing money. The only way to borrow money, and borrow at a cheap price, is to maintain a strong track record of paying back your lenders – interest and principal. Since 2008, most municipalities (General Obligation Muni’s) have been drastically cutting expenses and taking advantage of low yields to refinance and extend their maturities to later dates. Additionally, if you actually read through a prospectus, as I know everyone does, the bulk of these bonds hold precedence over some major obligations – even pension funding! I think you’ll see some major budget cuts before municipalities ever skip on interest payments.
The New York Fed recently published a report saying that Muni Bond defaults are also much higher than what has been thought/reported. While Moody’s has listed 71 defaults from 1970-2011, the Fed’s database shows 2,521 defaults during this same period. The significant difference is because Moody’s does not include defaults on unrated bonds, which tend to be either very small municipalities, or extremely unhealthy projects already on the verge of default. Additionally, if the Bush tax cuts expire and tax rates increase, you better believe people will continue to flock to muni’s for the tax-favorable interest. If you stick with Investment grade rated muni’s, or simply muni bonds with any rating, I think you can enjoy the interest payments all the way to the bank.
In terms of high yield muni’s, my approach is to stay broadly diversified through a fund with a few hundred different bond holdings and only buy on dips in price.
Corporate Bonds
Corporate balance sheets are the strongest they’ve been in probably 60 years. Most companies are extremely cash-rich and have been boosting stock dividends. Since bonds hold precedence over stock in the capital structure, this means little to no concern for default on Investment Grade corporate bonds, leaving only interest rate risk. Not only do you receive higher yields, but I see less default risk and lower volatility in corporate bonds than in Treasuries. For stability and safety, I’m holding money in both short and intermediate term IG corporate bonds.
High Yield Corporate Bonds
High Yield bonds can be tricky. A LOT of money has been flooding into high yield bond funds/ETF’s over the past few years as investors continue to search for yield, pushing spreads lower. Given this demand along with lower issuance, I expect future volatility to be lower than it has been historically but you need to be careful when investing. It’s not a good idea to invest with prices high (spreads low). I still like high yield corporates, but same as high yield muni’s, I think it pays to be patient and only buy on dips in price.
I’ve also been a fan of Floating Rate Notes (FRN’s) over the past few years as a way to hedge interest rate risk as these bonds tend to perform well when rates rise. Unfortunately there aren’t very many ETF’s for these bonds yet, so I think it’s still best to gain exposure through low cost mutual funds.
International/Emerging Market Bonds
Developed Nation International Bonds (primarily Japan and Europe), quite frankly, I am avoiding. However, Emerging Market Bonds are slowly becoming my favorite bonds out there. There are primarily 3 types of International Bonds available to invest in:
- Local Currency Sovereign Bonds (other government bonds issued in their own currency)
- US Dollar Denominated Sovereign Bonds
- US Dollar Denominated Corporate Bonds
(There are local currency international corporate bonds but the markets are fairly thin and hard for retail US investors to gain access to. The companies that issue USD denominated bonds tend to be larger, more stable companies.)
The Emerging Nations have made great strides over the past 15 years and now account for over 40% of the world’s GDP. Many countries boast extremely low debt-to-GDP ratios (unlike the United States at 100%) and run trade and current account surpluses. It’s also now far easier for emerging nations and companies within their borders to access financial markets. Credit qualities have been improving and the size/liquidity of the market has grown dramatically.
A major shift has occurred over the past few years as credit qualities (ratings) have improved for emerging nations. Countries are now able to issue sovereign bonds in their own local currency, rather than US Dollar denominated. This has opened the door for many corporations to issue bonds in the US Dollar denominated market. In 2000, Emerging Market USD Sovereign issuance was 8x greater than Emerging Market USD Corporate issuance. USD Corporate issuance passed Sovereign in 2003, and in 2011, was over 2x greater than Sovereign issuance. Additionally, since 2007, spreads of EM USD Corporate bonds have been trading in-line with BBB US Corporate bonds despite the Emerging Market index containing 75% Investment Grade bonds. This means you can invest in higher rated bonds with similar yields to the lowest rank of Investment Grade US bonds. Additionally, EM corporates offer lower interest rate risk from lower durations.
I see the Emerging Market USD Sovereign market continuing to shrink as credit qualities improve so I prefer to invest in EM local currency Sovereigns for their strong fundamentals and potential long-term currency appreciation, and EM US Dollar denominated Corporates to fill the gap between US Investment Grade corporate bonds and US High Yield corporate bonds. There are a growing number of ETF’s in this space, which I prefer over mutual funds, but please keep in mind that it’s important to track the ETF’s price against NAV and bid/ask spread.
I apologize for the longer post but this is an important topic as it makes up such a large allocation of pre-retiree and retiree portfolios. If you have any questions please feel free to contact me directly or post a question in the comments section below.
Thanks for checking out my blog!
-Nick
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