Tactics for Combating Low Bond Yields

Few experts predicted that bond yields would go even lower in 2014 than they were at the outset of the year, but they did just that. Ten-year U.S. Treasury bonds were yielding 3% as 2014 dawned; as we rang in 2015, the benchmark yield was hovering just under 2.2%.

The ongoing drip-drop downward of interest rates has sent fixed-income investors scrambling in all different directions. In Morningstar.com's Income & Dividend Investing forum, I recently asked our readers to share their strategies for investing in bonds today. If they're avoiding bonds due to low yields and worries that rising bond yields will eventually crunch bond prices, what are they investing in instead?

Reader responses ran the gamut. Some posters said they're forgoing--or at least reducing--their fixed-income allocations owing to miserly yields; dividend-paying stocks and preferred stocks were frequently cited substitutes.

Other investors said they are continuing to maintain a fixed-income allocation because they need bonds to serve as a counterweight to their equity stakes. But many such respondents also said they're moving beyond core "total return" products; they've ventured into multisector, bank-loan, and emerging-markets bond investments, to name but a few.

Still other posters said they've maintained a "better safe than sorry" policy, focusing on cash and cashlike investments, such as stable value, with dollars they had earmarked for bonds.

To read the complete thread or share your own strategy for fixed-income investing today, click here.

'I Avoid Bonds'

At age 42,

Rforno

doesn't see a great need for bonds; dividend-paying stocks and preferred stocks fit the bill: "I continue to hold/build/make positions in quality dividend-paying/reinvested, dividend-growing stocks and preferreds.

Even more downbeat on bonds is KathieL, who wrote, "I avoid bonds. I am 95% in equities, all dividend-payers, 5% in preferreds. I have recently retired and am comfortable with my allocation, as my portfolio yields significantly more than what I need to make up the gap between my pension and my spending."

Cliff is on the same page: "My strategy is to hold no bonds or bond funds. My objective is growing income from solid companies; therefore, bonds aren't even on the board to be considered."

Yogiman's positioning isn't quite as extreme, but this investor, too, is content to hold dividend-payers: "I am retired with 20% bonds, 10% cash, and 70% dividend-paying equities. So far, so very good!"

Expecting bond yields to stay down for a good long time, Intruder is also maintaining a heavy stock weighting: "I am 80% equity/20% bonds because there is very little fixed income that generates decent returns. I will remain with this asset allocation for the foreseeable future because I don't expect interest rates to rise to pre-recession levels since the Fed is committed to keeping inflation at 2% and oil prices will remain low."

BMWLover has been employing a multipronged approach to income generation; that portfolio includes a complement of dividend-payers: "[W]e own a basket of large-cap dividend-paying stocks that yield us almost 3%. The stocks offer upside potential as the share prices rise, and as the dividend payouts increase they offer the potential for rising yields as well."

Preferred stocks also received repeat mentions as alternatives to fixed-income investments. (See Cara Esser's article for a comprehensive overview of the asset class, including its risks.)

BMWLover laid out the case: "[Our] preferreds yield in the 5% to 6% range for investment-grade businesses... They are easily traded on the open market, which offers the liquidity that I like."

'Bonds Are a True Risk-Smoother' Other posters said they're sticking with traditional fixed-income exposure.

Tomas47

was one such respondent, writing, "I definitely continue to own bond funds as a part of my strategic asset allocation. My targets are 9% short term (

Also sticking with bonds is DollarBits, who's been unenticed by the valuations on alternatives: "Right now my bond allocation remains intact. During 2014, given the low yields, I have considered migrating a portion of my bond holdings over to utility stocks, but the utility stocks have remained quite overvalued for the entire year, so I remain in bonds."

When asked about jettisoning bonds, FD1000 replied, "No and [I] will never do it. Bonds are a true risk smoother. Bonds have several categories with lower correlation. There is a big difference between Treasuries to high yield to emerging markets to preferred to closed-end funds. I can always find bond funds that make money."

Scotsailor

also believes it pays to be opportunistic in bonds, but notes that the pickings are slim these days. "I still do buy some bonds, especially when an unloved category can be identified," this poster wrote. "High-yield munis (

Among investors who are sitting tight with bonds, several said that they've ventured out on the risk spectrum in an effort to pick up a better income stream.

ElLobo says that ultra-low yields on high-quality bonds necessitate a shift out on the risk spectrum: "I go down in quality or out in term for higher yields. A lot of us around here don't buy low yield anything, including equity!"

Yogibearbull concurred that declining yields have necessitated a more aggressively positioned fixed-income portfolio, away from core total return-type bond funds and into more specialized product types such as multisector, global, and emerging-markets funds. "I know that I am taking more credit risk and most of my bond portion may not act as ballast for the equity side," this poster wrote.

At the other end of the spectrum, several posters said that they're sticking with cash--and cashlike--securities in lieu of at least part of their bond allocations.

Fingerlakesguy wrote, "I haven't totally abandoned bonds. I still have about 20% in bond funds that cover a total bond market with intermediate duration, including some high-yield funds. The rest of my investments on the fixed income side are in a stable-value fund paying 3% total return and 5-year CDs at 2% that I purchased from Ally Bank when their penalty [for prematurely cashing out] was only 60 days."

Stable-value funds and guaranteed investment contracts (GICs) offer higher yields than cash with limited risk of principal volatility, but they're typically found only inside of company retirement plans. The higher yield of a GIC is a key enticement of an old 401(k) plan for Investormug, who wrote, "Four years post-retirement and [I'm] still holding 20% of my total portfolio in [my former employer's] 401(k) income fund, a GIC currently yielding 3.5%."

Cherie is taking multiple tacks to combat low bond yields: "In my IRA, I invest in a ladder of short to intermediate-term noncallable brokerage CDs which I roll over at maturity. It minimizes market risk (because I hold until maturity), earns more than money market mutual funds would, has no fees, provides government bond-like diversification, while the periodic maturation provides liquidity. I'm within FDIC limits for each bank obligor."

'As Long As It All Beats Inflation, I'm Happy' Numerous posters said they're confronting the "bond problem" from multiple angles, holding bonds and income-producing stocks, as well as safer securities such as stable value and cash.

Intruder is among the investors employing a multipronged approach, writing, "My fixed portion includes long-term muni bonds bought in 2009 paying 5%, preferreds, master limited partnerships generating 7%, and muni closed-end funds with 6% dividends." Intruder went on, "MLPs and muni closed-end funds are tax efficient investments whose income does not show up on the 1040, which allows me to put more qualified dividends into the 15% tax bracket with 0 tax." (Investors in the 15% tax bracket and below pay 0% tax on qualified dividends.)

Macpiano

is employing something of a barbell strategy, with lower-quality bonds as well as cash/cashlike investments. "I did not pay much attention to my holdings this year and made no changes but two years ago I decided to put 11% of my portfolio into