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By Christine Benz | 10-23-2014 09:00 AM

What to Do With Bonds Today

Given the difficulty of timing interest-rate moves, author Rick Ferri recommends a diversified blend of high-quality bonds, high-yield credits, and a touch of TIPS.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I'm here at the Bogleheads Conference, and I'm joined today by investment expert Rick Ferri.

Rick, thank you so much for being here.

Rick Ferri: Thank you, Christine, for having me.

Benz: Rick, I'd like to talk about bonds and how investors should be approaching bonds at this juncture. There has obviously been a lot of consternation about the asset class, and one strategy that I've heard from investors is that they are just going to hunker down in short-term bonds or maybe even cash until this whole thing blows over. What do you think about that as a strategy?

Ferri: So, the strategy of lowering your duration or the maturity of your portfolio based on a person's expectation of higher interest rates, I would assume, then that person would then get back into bonds at some time, so it really is requiring two trades, if you will. One, when am I going to get out to get into short-term? And then two, when am I going to get back in? The probability of being right with both of those is very low.

So, what if you just stayed intermediate-term during the whole time? During this whole period since 2008, when interest rates literally want to zero, what if you just stayed intermediate-term and picked up 2% or 2.5%? Well, if you accumulate that over the last five to six years, you've actually picked up 10% to 12% extra in your portfolio if you didn't make the assumption that interest rates were going to go back up and, therefore, you are going to get hurt. In other words, this is called opportunity cost.

If you make this determination to get out of intermediate-term bonds and go into short-term bonds and then go back into intermediate-term, that's an opportunity cost. I think that people who have talked about and done this have really risked their portfolio and have lost out because they've missed the opportunity to get intermediate-term bond yields. I've never been an advocate of lowering your portfolio unless you needed to, because you're going to be taking the money in the next couple of years. That's a different story. That's a need-based thing. It has nothing to do with the yield curve.

I'm not in the camp of "lower your maturities and get ready for higher interest rates." I have never believed that, and I've never been in that camp. And it may happen--I don't know when--but in the meantime, if you do it, you're missing out on some pretty decent yield from intermediate-term.

Benz: When we look at fund flows, another area where we see very strong investor appetites is in the area of more credit-sensitive bonds--high-yield and bank loans, and maybe even emerging-markets bonds. How do you think about those asset classes? How should investors be approaching them at this juncture?

Ferri: So, you're really speaking about high-yield corporate?

Benz: Or bank loans or emerging-markets.

Ferri: Well, bank loans are high yield.

Benz: Yes.

Ferri: Just a different type. People are stretching for yield because they want to get the income. And I think that having an allocation to high-yield is good. In my bond portfolio, I've always had a 20% allocation to a low-cost, high-yield bond fund.

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