Picking bonds harder, customization easier

Buying individual bonds for client porfolios used to be easier.The two big factors to consider — duration and credit risk — could be handled in a straightforward manner.

Duration decisions could be based on when clients needed funds, or a laddered approach could be used for flexibility and reinvestment. Alternatively, buying bonds in the “belly of the curve” — three- to five-year maturities — usually was a good way to capture yield without taking on too much duration risk. For credit risk, the major ratings agencies provided reliable guidance. In the municipal market, defaults were rare and insurance was available for many bonds, so choosing bonds was more about capturing the best tax-exempt yield.

Today, advisers are faced with more-challenging decisions. With the Federal Reserve committed to keeping short-term interest rates at zero for at least another year and a half and making every effort to suppress long-term rates, interest rate risk has risen. Just shortening duration in the face of interest rate risk produces unacceptably low yields for most investors. The ratings agencies no longer are seen as reliable in light of their failure during the mortgage meltdown, and credit risk now is a much bigger component of the muni market than in the past.

Additionally, advisers have more and more options in terms of where and how to buy bonds.

The rise of alternative-trading systems makes the process of buying bonds more transparent and, at times, more efficient than calling around to various broker-dealers for quotes on bonds that they might, or might not, have in inventory. There also are firms that aggregate quotes from the alternative-trading systems, allowing advisers to get prices on bonds without ever calling a trading desk. But that means advisers need to seek out bonds instead of waiting for a call from a broker. While it's good to have options, it means learning new ways to conduct business.

LESS DIVERSITY

The “core and explore” strategy is a good starting place for most bond portfolios. However, the core has changed. For advisers who are accustomed to using an index fund that tracks the Barclays Global Aggregate Bond Index for core portfolio holdings, the problem is that the index no longer is diversified. In the aftermath of the financial crisis, about 80% of the bonds in the index now are effectively part of the U.S. Treasury market. In addition to Treasury securities, which make up about 30% of the index, mortgage and agency securities account for another 50%, leaving only about 20% of the index in corporate bonds.

Moreover, yields are low on Treasury securities due to the Fed's zero interest rate policy, and the duration of bonds in the index has been extended due to changes in the mortgage market. So an index-type approach no longer provides diversification, and it's longer in duration and lower in yield than most clients would like.

Therefore, to achieve diversification in core holdings, advisers must look beyond the standard benchmark index to other types of bonds. A combination of Treasury securities, U.S. investment-grade corporates and municipal bonds, along with Treasury inflation-protected securities, is appropriate for core holdings. Core holdings should be high quality because they provide ballast for the overall portfolio. Treasuries and TIPS can have longer-term duration, in the five- to 10-year range, where credit risk is low, while the duration for corporate bonds should be kept shorter.

In the search for yield and diversification, there are many potential sector choices useful for different purposes. Bonds of developed foreign countries can be a good diversifier and do well when the U.S. dollar is declining, but add currency risk. High-yield bonds provide more income, but returns are correlated with the stock market, and emerging-markets bonds combine higher credit and currency risk, but provide diversification and yield.

With online bond buying growing more popular, advisers may need to focus on details for which they relied on brokers in the past, such as whether and when the bond is callable, if it is on watch for a ratings change and where it sits in the capital structure of the issuer.

Overall, because the bond market has changed, selecting bonds today presents different challenges than in the past, even as advisers have the ability to offer more customized service to clients.

Kathy A. Jones is a vice president and fixed-income strategist at the Schwab Center for Financial Research.

Related Topics: Investment Strategies