Bonds are usually issued at par, redeemed at par, and along the way they fluctuate in value as prevailing interest rates change. Their total performance closely tracks inflation expectations. So real growth--if any--is too small to be meaningful. Investors often view them as safe, however the volatility of long-term bonds might be as high as that of stocks, while their return per unit of risk is anemic in comparison. To include insult to injury, long-term bonds have a higher correlation to other financial assets, and they perform abysmally during periods of high inflation. bonds to invest in
In general, the characteristics of bonds as an advantage class are very dismal that you could wonder why any investor will need them at all. Of course, not all investors have similar needs. Many institutions are far more interested in matching future liabilities with assets than maximizing total return. For instance, life insurance companies can estimate their future liabilities with some precision. Having bonds that mature on schedule allows them to fit assets with expected requirements. Statutory regulations require them to put up bonds to back up their obligations. To oversimplify, insurance companies mark up the price of providing benefits to compute their premiums. Total return isn't as important while the spread.
That's not the situation we face as individual investors, though. We want to maximize our return per unit of risk, and bonds don't fit in very well. When we plot the risk/reward points for several well-known long-term bond indexes from 1978 to 1997, we observe that they all fall far below the conventional risk-reward line. Not really a pretty sight, is it?
Within the 20-year period, various classes of bonds all land well below the risk-reward line between T-bills and the S&P 500 index.
Bonds have only two useful roles to play inside our asset allocation plans: They could reduce risk to tolerable levels in a portfolio, and they are able to provide a repository of value to fund future expected cash-flow needs. Of course, we don't expect the bond percentage of the portfolio to become a dead drag on its overall performance. It makes sense to take prudent steps to boost returns in most percentage of the portfolio. Let's take a look at a few of the common methods employed by fixed-income investors to see if any might advance that goal.
Junk Bonds
Investors undertake more risk if they spend money on lower-quality bonds. While they are able to increase total return because they move from government bonds to corporate to high-yield (junk), investors simply don't get paid enough to justify the risk. They remain hopelessly mired below the risk-reward line.
Active Trading
Most of us know that the capital value of a bond whipsaws as interest rates in the economy change. So, if we'd a precise interest-rate forecast, we could create a trading strategy to reap capital gains. Buying long-term bonds before interest-rate declines will produce gratifying profits. Pretty simple, huh? The problem is, accurate interest-rate forecasts are elusive. Seventy percent of professional economists routinely fail to predict the correct direction of rate movements, let alone their magnitude.
Individual bond selection is suffering from exactly the same problems as equity selection. The market is efficient, and finding enough mispriced bonds to make the effort worthwhile is problematic. It shouldn't surprise us that traditional active management of bond portfolios fails every bit as profoundly as does active equity management.
Riding Down the Yield Curve
Borrowers generally demand additional return for holding longer-maturity bonds. The connection between maturity and return is expressed while the yield curve. When longer-maturity bonds have higher yields, that will be most of the time, the yield curve is said to be positive. As you can see in the graph below, yield typically rises very gradually, while risk will be taking off sharply beyond a one-year maturity. On a risk/reward basis, bonds with maturities of more than five years are often not attractive at all. Hence, investors are well advised to confine themselves to the short end of the spectrum.
As a bond's maturity increases, the slope of the risk line is a lot steeper compared to the slope of the return line.
However, a straightforward passive technique that I call "riding down the yield curve" can improve yields at the short end of the curve. If the yield curve is positive, simply purchase bonds at an optimum point where interest rates are high, hold them until an optimum point to offer at less rate. This captures both yield on the bond although it is held, and a capital gain on the difference in price. Through the few instances when the yield curve isn't positive, simply hold short-term bonds. Nothing is lost as the rates are higher here anyway. While the procedure involves trading, it generally does not require any kind of forecast to be effective. The yield curve is just examined daily to determine optimum buying and selling points. To be effective on an after-trading-costs basis, only the most liquid bonds (U.S. Treasury and high-quality corporate bonds) could be used. Over time, a bond portfolio having an average duration of only two years could be enhanced by 1.25% by using this technique.
Foreign Bonds
Theoretically, at the very least, the largest reason behind yield differences between foreign and domestic bonds is currency risk. If you're to completely hedge currency risk, you should theoretically be straight back at the T-bill rate. But in true to life, opportunities exist to get short-term foreign-government bonds, hedge away the currency risk, and still have a higher yield. Benefiting from these "targets of opportunity" can further enhance a short-term bond portfolio, perhaps by a portion point or two. Of course, if there are no such opportunities during a certain period, just buy domestic bonds.
