More than 25 percent of bonds are yielding less than zero percent. That means when the bonds mature, owners will receive less than they paid for them. This is a scary scenario for any bond investor as security of principal and low-risk returns are the main reasons to hold bonds.
This begs the question: Should the average investor hold bonds? For most investors, the answer remains yes. However, it will pay to be more selective than you might have been in the past.
For individual investors, typical reasons to hold bonds are obtaining a steady income with a high level of security of principal, and diversifying a portfolio against stock-market declines. Some of these goals can still be met in today’s world, but the risks of holding bonds has increased and some benefits have decreased.
For investors looking for income, decreasing interest rates have reduced the coupons on new bonds. The only ways for investors to maintain the same level of income has been to buy longer-term bonds with higher coupons or lower-quality issues. Both of these options increase your risks.
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As rates have gone negative on many European and Japanese bonds, investors have increased investments in U.S. bonds and higher-yielding, lower-quality bonds. This has driven down the yields on these bonds, making them less attractive and increasing the risk of being compensated for the additional interest rate and credit risk.
This has led many investors to leave bonds entirely and look to dividend stocks, Real Estate Investment Trusts, gas and oil pipelines, and alternative investments to generate the income they desire. Although decreasing your bond allocation might make sense, abandoning it entirely does not. There are still some bond sectors that offer reasonable returns for the risks taken and offer diversification benefits not available in an all-equity portfolio.
Although the current round of negative interest rates has only been with us for a little more than two years, some winners and losers have become apparent. Since the U.S. economy is in better shape than most other developed countries, we are seeing an influx of international investors buying our bonds. This has helped buoy the prices of U.S. Treasury as well as high-quality municipal and corporate bonds.
If you already own these bonds, this is good news. For new purchases, the lower yields of these high-quality bonds don’t offer much return. They do maintain a high level of safety of principal. The bad news is that this increases the value of the dollar and may hurt our exports and economy in the long run.
U.S. company stock prices have increased, making chasing yield there very expensive. High-yield bond prices in the U.S. and elsewhere also have increased. The return on these issues might not cover you for the increased risks you are taking. With economies in China and Europe starting to show signs of recovery, emerging market stocks and bonds have increased in value, due to their higher yields.
There are still some opportunities in higher-quality U.S., international and emerging market bonds and stocks. Industries that perform better in low-interest rate environments should do better, assuming rates will be lower than normal for an extended period. Look for companies and countries that have good financials and the ability to pay the coupons or maintain dividends. Some of these include real estate, pipelines, utilities and infrastructure industries.
Remember that owning bonds helps to balance your portfolio and hedge against stock-market declines. Even if you move out of bonds to generate more income, holding some, say 50 percent of your normal fixed-income portfolio allocation, will help cushion equity price declines.
We are in a different world with low or negative interest rates affecting all investment markets. Despite what the experts say, no one knows how it will turn out. You can protect yourself by evaluating potential short-term scenarios and making small moves to your successful long-term portfolio allocation. If you do not have an investment plan, now is the time to develop one to help you meet your long-term income and growth goals, and guide you in the short term.