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By Christine Benz | 03-23-2013 10:00 AM

Practical Strategies for Today's Bond Market

The outlook for bonds is just as cloudy as ever, but Morningstar's Miriam Sjoblom and Marta Norton offer helpful tips for setting the right expectations and creating a game plan in today's challenging bond market.

The following is a replay from the 2013 Morningstar Individual Investor Conference.

Christine Benz: Hi, I'm Christine Benz for, and welcome to [our] second session, Practical Strategies for Today's Bond Market. In this session, we are going to be discussing many of the headwinds confronting fixed-income investors today, and we'll also talk about some practical strategies for confronting them. We will, as always, throughout today be accepting questions from our audience, and in fact, we welcome them. So, if you would like to submit a question, please click the 'Ask a Question' button next to your viewer.

I'm happy to say that I'm joined here today by two of my favorite bond experts. Marta Norton is here from Morningstar Investment Services. She is an investment manager there. Prior to assuming her current position, she was a senior fund analyst with Morningstar, and before that she was an economist at the Bureau of Labor Statistics. She is a CFA charterholder.

Miriam Sjoblom is also here. Miriam is associate director of fund analysis with Morningstar, and she is also head of our active fixed-income coverage. Prior to joining Morningstar in 2007, Miriam was an investment analyst within Citigroup's investment banking division. She, too, is a CFA charterholder.

Miriam and Marta, thank you so much for joining us here today.

Miriam Sjoblom: Good to be with you.

Marta Norton: My pleasure.

Benz: So, obviously, it's a tough time for fixed-income investors. When I go out and about the main think I hear about is bonds and how people should manage their bond portfolios. So, I thought a good structure for today's discussion would be to talk about some of the strategies that we hear people are employing, and I thought we could just start with the first one, which is, why do I need bonds in my portfolio at all?

Yields are really low; prospective interest-rate hikes could crunch bond prices. Should I just forgo this asset class in my portfolio altogether? Marta, I am hoping you can tackle this question because I know you're involved in managing portfolios for Morningstar Investment Services. Let's talk about how you would approach this question?

Norton: Right. And I think that is a good question. Obviously, one of the big advantages to a bond is the fixed income it's producing. So, obviously, if it's not producing as much income, investors have reason to call it into question. But I think there are still advantages to fixed income even if the income isn't that high, and it mainly comes down to portfolio construction.

[Bonds] act as risk mitigators in a number of different ways. One, if you're just looking at it from the perspective of diversification, bonds have low correlation historically with the equity market. I mean, Treasuries, in particular, are the segment of the bond market that are actually negatively correlated with the equity market. So when the equity market is maybe tanking, bonds are going to be holding up and offering some stability to portfolios.

And then just if you look at typical risk measures like volatility, like drawdowns, bonds have exhibited less volatility than the stock market. They typically have less severe drawdowns than the stock market. So for investors who are maybe approaching the point at which they are going to tap their assets, an asset class that's offering stability is not one to avoid altogether or to sell out of altogether. They are stability producers for portfolios.

Benz: So one topic I would like to discuss and maybe you can address it Miriam, is this issue of what happens when yields rise. I think people are really worried about that scenario and realistically it's a possibility in the decades ahead. So, let's talk about as yields rise that depresses the prices of existing bonds. But you get some of that back as yields rise, right? It's just sort of a time-lag effect.

Sjoblom: Right, right. The neat quality of bonds is as yields go up, you suffer some pain in the short term but then you're earning a higher yield on your money. So there's kind of this mechanism built into bonds that whereby over time you can get some of that loss back.

Benz: One thing I often hear from investors is that they are saying, I think I'm just going to build a laddered portfolio of individual bonds. That way I'm not buffeted around. I'm not in for those potential principal losses if yields go up. What do you say to that strategy? And where does buying individual bonds makes sense? Where does it not makes sense?

Sjoblom: Well I think the most important thing is diversification and unless you have a very large sum of money to invest, it can be very difficult for you to get good diversification because there is just a chance that one credit in your portfolio, something unexpected could happen and you lose some of your principal. So, that's a big concern. You get much better diversification, in general, from a bond fund.

The other thing would be trading costs. It can be very difficult for investors to have the size and the market knowledge to be able to get a good price on their bonds and to get good transaction costs. Institutional investors by far in a way have an advantage when it comes to trading bonds. So, liquidity is another thing. If it's difficult to trade and you need to liquidate your holdings, you're going to pay for it. So, those are considerations I think that make it really challenging to be successful investing in individual issues, if you're an individual investor.

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