Sometime in the near-ish future, the Fed is going to raise interest rates for the first time in over five years. When they do, the companies and governments that have been issuing bonds at rock-bottom rates for years will have to start offering more favorable terms. That’s going to be nice if you’re buying new fixed-income instruments, but all the bonds issued with super low coupon rates in the last five years are going to become pretty unappealing to investors. And their prices will fall.
How should independent income investors prepare for this inevitability?
First, don’t get stuck holding bond funds. Bond funds are a particularly bad place to be when bond prices go down, for a couple reasons. Systems & Forecasts Editors Gerald and Marvin Appel explained these reasons well in a recent issue of the Dividend Digest. Here’s what they wrote (emphasis mine):
“If interest rates rise further, the Total U.S. Bond Market ETF (AGG) will continue to fall. What worries me about this scenario is that there is no limit to how much one could lose. This is because there is no principal guarantee when investing in bond ETFs and bond mutual funds. The managers for these investment vehicles are not required to hold bonds until maturity, which means that they could realize a loss by selling the bonds for less than they paid. Moreover, proceeds from old bonds maturing are sometimes used to buy bonds at a premium (above $100), which means the fund manager will realize a principal loss even if he/she holds to maturity.”
If you hold individual bonds, you’re in a better position. Yes, the bond prices will likely decline, but if you hold the bonds until maturity, you will still receive the same total return on the investment as if the price hadn’t moved. Here’s how the Appels explained it:
“When you buy an individual bond, you know at the time you invest what your total return will be if you hold until maturity. The assurance of a return even if interest rates move against you (absent a default risk) represents a high degree of safety. In contrast, with a bond mutual fund or ETF, there is no guarantee of investment return over any time period.
“The only interest rate risk in holding individual bonds until maturity is the possibility of lost opportunity: If rates rise, you could have locked in a better return. Nonetheless, regardless of what happens to interest rates, you will receive the expected return provided you hold the bonds until maturity. (If you sell before maturity, you do bear the risk of losing principal in the event that interest rates have risen.)”—Gerald Appel and Dr. Marvin Appel, Systems & Forecasts, 7/5/13
The Appels recommend sticking to bonds maturing in the next 10 years. In addition, they recommend buying only investment-grade bonds, whether issued by governments or corporations, to minimize default risk.
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If you want to hold part of your income portfolio in individual bonds, you can also use a strategy called bond laddering that keeps things neat.
Here’s how Cabot Benjamin Graham Value Investor Analyst J. Royden Ward explained bond laddering in a recent column for Cabot Wealth Advisory:
“Most investors are familiar with bond laddering. Just to quickly review, you can buy bonds with various expiration dates. The bond issuer will pay you the full principal amount of your bond when it expires.
“I advise investing in one-year, two-year, three-year, four-year and five-year bonds. A five-year ladder works best when interest rates are rising. The interest yields won’t be great, but your yields will increase with each passing year.
“When your one-year bond matures a year from now, your four other bonds will each be a year closer to maturity. Each year, you’ll replace the maturing bond with a new five-year bond—thus keeping your ladder intact.
This is a good strategy for a rising interest rate market, which is what we’re going to be facing over the next few years (and most likely decades). It keeps the income flowing without tying up too much of your money in low-interest-rate instruments for too long.
Roy also agrees that investors who want to hold individual bonds should focus on the investment-grade end of the credit risk spectrum. Here are his recommendations for where to look:
“Current yields on U.S. Treasury bonds and notes are low, but the safety of owning U.S. Treasuries will put your mind at ease. You might also consider municipal bonds in your ladder. Munis, as they are often called, are available at reasonable prices.
“Muni prices declined when Detroit filed for bankruptcy. Tax-free municipal bonds with good quality ratings and backed by general tax revenues are now priced to yield more than Treasuries of the same maturity. If needed, you should contact your broker to get help choosing the right munis for your five-year ladder.
“If you want higher yields, consider lower quality corporate bonds, but not low-quality ‘junk’ bonds. Lower quality corporate bonds rarely default during an economic expansion and provide considerably higher yields than municipal or Treasury bonds. Again, contact your broker to find bonds that will fit your objectives.”
Do you own individual bonds in your income portfolio? Have you tried bond laddering or any other approaches to create a reliable income stream? Let me know by leaving your comment below.
Wishing you success in your investing and beyond,
Chloe Lutts Jensen
Editor of Investment of the Week
P.S. If you’re looking for returns of 37%, 38% or even 47%, look no further. Dividend-producing investments we recommended in Dick Davis Dividend Digest produced these total returns in just the first six months of 2013.
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