Bonds have done so poorly this year that many investors probably are wondering what the point is of owning any.
People usually buy fixed-income investments to add stability to portfolios in addition to collecting regular income—but that strategy has backfired this year. Funds that track the US bond market have shed around 16%, their worst showing in decades. And long-dated US Treasurys have crered about 34%, versus a 21% drop in the S&P 500 index.
It’s unsurprising that many are fleeing the bond market, but those investors could be missing some key points, experts say. The market now may not be far from its cyclical low. And even if it doesn’t recover quickly, bondholders will continue to enjoy a decent stream of interest payments.
Moreover, with yields having risen “so ruthlessly,” it’s a good time to lock in much higher rates than were available in recent years, says Mike Mulach, a senior manager research analyst at Morningstar Inc.
He adds: “This is a tremendous opportunity.”
Much danger continues to lurk in the market, though, so income-seeking investors need to be speculative, market professionals say. Here are a few ways to get income with less risk:
1. Hold an individual bond to maturity
Bond prices move inversely to yields, so as the Federal Reserve has lifted rates to slow growth and damp inflation, most bonds have lost principal value—at least on paper. But, barring a default, someone who keeps an individual bond to maturity will get back all of the initial outlay as well as interest. The caveat is that choosing individual bonds poses some complexity, so it might be helpful to work with an advisor or broker when buying them.
Some bonds issued by state and local governments now yield about 4%, well above the level a year ago, notes Jason Ware, head of municipal trading at InspereX, a bond underwriter and distributor. Because interest may be exempt from federal and state taxes—depending on the type of bond and where an investor lives—that could mean an after-tax yield as high as 8% for those in top tax brackets, he says.
2. Focus on total return, not just yield
People with less to invest often pick intermediate-maturity bond funds, which are designed to provide broad market exposure and may require an initial outlay of just $1,000.
Those funds have been slammed because they own a lot of rate-sensitive bonds such as Treasurys and other highly rated securities (generally speaking, the longer the term and the higher the rating, the more rate-sensitive bonds are) and—unlike individual bonds —have no final maturity.
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But performance is expected to improve, and “it’s beginning to look somewhat compelling” to have a meaningful allocation to core US fixed income, says Jeffery Elswick, director of fixed income at Texas-based Frost Investment Advisors. His reasoning: Once the Fed returns to cutting rates, which some market watchers predict could happen as early as next year, many of the intermediate bonds that currently have big principal losses will rebound at least partly in value, providing an opportunity for capital gains.
Intermediate funds usually hold maturities of around four to 10 years, so a less-risky way to approach such strategies is to plan on owning them for at least several years, experts say. A rule of thumb for choosing a bond fund is that investors should roughly match a fund’s rate sensitivity, or duration, as shown on its fact sheet, with their own investment time horizon. Rick Lear, a portfolio manager in Dallas, suggests looking at funds from a total-return perspective—the potential principal loss or gain in addition to yield—and considering the potential impact on performance.
Among intermediate funds highly rated by Morningstar is Pimco Total Return (PTTAX), which yields more than 3%, charges 0.80% in expenses and is down about 17% this year. An exchange-traded fund option to consider is a Vanguard Intermediate-term Bond (BIV). It charges 0.04% in expenses, yields 4.9% and is down about 16%.
3. ‘Laddering’ variant
A more conservative, short-term strategy that might appeal to someone with cash but who is nervous about committing a lot to the bond market just yet could be buying short-term securities and, when they mature, reinvesting the proceeds at then-higher rates . It’s a variation on a strategy known as laddering—owning the same type of bond with maturities spaced over several years—and could work well as long as yields still look to be rising.
For example, using a brokerage or Treasurydirect.gov account, someone could buy eight-week Treasury bills—which yield about 4% —and continue to reinvest in those short maturities until it appears that rates have plateaued. The investor then could lock in yields for longer by shifting into two-, three- or five-year Treasury notes, where yields also are attractive. Such an approach could enable the investor to get a better return than from a savings account while waiting to see how events unfold.
The challenge is timing, says John Kerschner, a senior portfolio manager at Janus Henderson Investors. Even professionals can’t accurately forecast rates. Mr. Kerschner says inexperienced investors may be better off owning a floating-rate fund, whose yield automatically moves up or down with market rates. Other types of bond funds usually own securities with fixed coupons, which lose principal value when rates are moving upward.
4. Float higher as rates rise
Many floating-rate funds own bank loans made to companies with lower credit standing to enjoy higher rates. The funds’ yields edge upward as rates rise and now stand around 4% or more. But managers of some of these funds take more credit risk than others, says Morningstar’s Mr. Mulach, so fears of recession could hurt performance.
Fidelity Floating Rate High Income (FFRHX), yielding nearly 8%, is a more risk-averse option, according to Morningstar, which gives the fund a silver rating, its second highest. An investor also could choose a floating-rate fund that holds investment-grade securities, such as WisdomTree Floating Rate Treasury ETF (USFR), yielding around 3%.
Once rates pass a cyclical peak, floating-rate yields will slowly start to trend lower, says Mr. Elswick at Frost. He suggests trimming these types of holdings “once the Fed hits the pause button” on rate increases.
5. Limit both credit and rate risk
Funds that focus on the one- to three-year area of the investment-grade corporate debt market are worth considering, says Lawrence Gillum, fixed-income strategist at LPL Financial. While those also have gotten hurt this year, losses are smaller because they focus on less-rate-sensitive maturities. Performance likely will improve as their managers replace maturing securities with new ones issued at lower prices and higher yields, experts say.
Mr. Gillum prefers active managers, who he says can sit through the diverse market for the best opportunities. But such funds also come in a low-cost ETF format.
SPDR Portfolio Short Term Corporate Bond (SPSB) ETF—off about 5% this year—yields above 5% and charges just 0.04% in expenses. Short-term corporate bonds offer “pretty good compensation,” based on yields and their limited rate risk, says Matt Bartolini, head of SPDR Americas Research at State Street Global Advisors.
Mr. Pollock is a writer in Pennsylvania. He can be reached at email@example.com.
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