Avoiding Bond Market Woes Doesn't Come Without Trade-offs

"Because of my age in retirement, I need to be in 60%-70% bond funds. There are constant warnings about the bond bubble, increasing interest rates, and the potential plunge of bond funds. What are the ways to address this?”

A Morningstar.com reader post in a Discuss forum thread neatly summed up the conundrum for many fixed-income investors, especially those in or nearing retirement. What to do when the asset class you're supposed to be holding for ballast looks to be on somewhat shaky footing itself?

Morningstar.com readers have been discussing a variety of strategies over the past few years, all designed to help their portfolios avoid major losses if and when anticipated interest-rate hikes materialize. Many of these strategies don't look entirely off-base to me--for example, I don't think it's unreasonable to take a slice of the assets you had earmarked for bonds and move it into dividend-paying stocks. But moderation is key for all of these approaches, as is a full understanding of the trade-offs you're making as well as what could go wrong.  

The Strategy: Forgoing Funds, Buying Individual Bonds Instead
At first blush, rising rates would seem to be a bigger problem for bond funds than bonds at large. After all, if you buy an individual bond from a high-quality issuer and hold it to maturity, you can simply collect your income and receive your principal back when the bond matures, regardless of interest-rate changes.

Bond-fund holders, by contrast, won't necessarily be assured a return of their principal, and the interest they receive from their bond funds could also fluctuate. That's because the bond-fund manager is overseeing a basket of securities whose value must be tallied each day; that value depends on the price of each of the securities in the portfolio at the end of that day. And if interest rates rise, the value of the bonds in the portfolio could get marked down, because investors would rather have new bonds with higher yields than the fund's older bonds with lower yields. The manager can also sell bonds prior to their maturity at a higher or lower price than what he paid.

What to Consider First: Even though buying individual bonds might help investors sidestep the kind of direct interest-rate risk that bond-fund holders face, the strategy is only appropriate for a component of an investor's bond portfolio; it's also far from risk-free.

For starters, individual investors may have trouble unearthing good research on individual companies and municipal bonds (though Morningstar aims to lend a helping hand with its bond research). They may also have trouble building adequately diversified portfolios and may face high bid-ask spreads, unless they have exceptionally large portfolios. That's why Morningstar director of fixed-income research Eric Jacobson has stated that bond investors are better off with funds if they're venturing into lower-quality corporate bond, municipal bonds, or even TIPS, while it's not unreasonable to buy individual bonds when seeking Treasury or high-quality corporate exposure.

Opportunity cost is another risk of sticking with individual bonds: While individual-bond investors won't see their principal values decline if interest rates jump up, nor will they necessarily be able to take advantage of higher-yielding bonds as they become available. Thus, individual bond investors should consider laddering their purchases to avoid locking themselves into today's low rates.

The Strategy: Shunning Treasuries
As Treasury bond prices have jumped and their yields have shriveled, the bonds have looked like a bad bet to many investors. Add in the fact that government bonds are often the most sensitive to interest-rate changes and it's not hard to see why some investors have even been discussing "Going naked" Treasuries--shunning the sector entirely, even though the bonds compose a large share of the U.S. bond market. (Carl Kaufman from  Osterweis Strategic Income (OSTIX) recently quipped that Treasuries could be "the safest place to lose money.") That turned out to be a bad bet in 2011, as government bonds outperformed nearly every other market sector, but it could pay off if the economy continues to pick up steam and inflation increases.

What to Consider First: Because Treasuries don't appear to offer a terrific risk/reward trade-off at the moment, it's a good idea to check your bond portfolio's positioning to see how much the sector consumes; this article provides some guidelines for benchmarking your fixed-income weightings. If you have actively managed general bond funds in your portfolio, it's possible they've already reduced your exposure for you. If you're using a total bond market index fund as your core fixed-income holding, be aware that it has more than two thirds of its holdings in bonds issued by and related to the U.S. government; thus, you may want to augment it with holdings that provide exposure to non-government sectors such as corporate, muni, and asset-backed bonds.

But before you do a complete purge of government bonds, stay mindful of the fact that in a true market shock, few asset classes will provide the same ballast that Treasury bonds will. Amid the European debt crisis in the third quarter of last year, for example, intermediate-term Treasury indexes gained nearly 6%, whereas intermediate-term corporate and munis gained less than half that much.

The Strategy: Staying Short
In addition to downplaying Treasuries, one other strategy for fending off interest-rate shocks is simply to stay short, favoring cash and short-term bond vehicles over those that play at the intermediate and long end of the yield curve. Given that interest rates have much more room to move up than they do down, the thinking goes, the risk-reducing benefits of staying short outweigh the bonds' meager yields.

What to Consider First: Although long-term bonds outperformed nearly every other asset class last year, the risks of long-term bonds at this juncture would seem to outweigh their upside potential. (Full disclosure: I was saying the same thing a couple of years ago and I've been wrong.) But before you embark on an aggressive campaign to shorten up your portfolio, first take stock of how your investments are positioned; many active fund managers have proactively reduced their weightings in long-duration bonds over the past few years. Check out the durations of the bond funds in your portfolio to see their interest-rate sensitivity and gauge your comfort level with losses given various interest-rate scenarios; this article provides some guidance on how to interpret those numbers.

The Strategy: Buy Dividend-Paying Stocks Instead of Bonds
Yet another strategy favored by some Morningstar.com readers is to swap into dividend-paying stocks instead of bonds. The former have, in some cases, yields that are as high as high-quality corporate bonds, and they also offer the potential for dividend growth and capital appreciation. Moreover, dividend-paying firms are, by and large, in much better financial health than they were even a few years ago, making dividend cuts much less of a concern. Thanks to those attractions--as well as the stocks' exceptionally strong returns in 2011--dividend-paying funds and ETFs have gathered tremendous assets over the past few years.

What to Consider First: While it's not unreasonable to take a 10% or 20% slice of your fixed-income portfolio and move it into dividend-paying stocks, I've argued before that the asset classes are far from interchangeable. Even high-quality dividend-paying stocks have a much higher risk and volatility profile than do bonds, a particularly important consideration for investors who may need to tap their capital for living expenses within the next several years. It's also worth noting that dividend-paying stocks may have some sensitivity to rising interest rates, as investors swap out of the stocks in favor of newly issued, higher-yielding bond funds. Historically, utilities, financials, and real estate have been among the most rate-sensitive portions of the dividend-paying universe.

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