The lowdown on low-yielding bonds

Joel Dresang: Steve, interest rates are at all-time lows. The 10-year Treasury yield hit rock bottom this summer. Around the world, yields on some bonds are actually negative. Let’s talk about the importance of all this in terms of bondholders. Your position is that bonds are still an important part of an investment portfolio. Why is that?

Steve Giles: Joel, I think it’s important for investors to remember that bonds help to reduce your overall volatility. Bonds provide stability. And for those investors in retirement, they provide an important place to lean on during periods of market weakness for portfolio withdrawals.

Joel: So, with historically low yields on bonds, what should bondholders be expecting right now?

Steve: We think that yields in the short term are going to stay in the low range but eventually trend higher. Keep in mind that last year, in December, the Fed started to raise rates. They put that on hold for a while with some uncertainties around the globe, but what we think is going to happen is that the Fed will continue to raise rates. They need to eventually return to a more neutral monetary policy, and that’s important for investors because it helps us in guiding the way that we’re going to position their bond portfolios.

Joel: And when those rates go up we expect bond values to go down. That’s the relationship, so what should bondholders be doing about that?

Steve: That’s absolutely right, Joel. As rates go up the values of our bonds go down. It’s very important in a rising rate environment for bondholders to focus on more shorter and intermediate durations.

With short and intermediate durations, you have money coming due more frequently. As that money comes due, you’re able to then reach out into the higher yields that are becoming available, in effect, seeing a rising yield of your bonds through this rate tightening cycle. You will see a pullback in your NAV, but hopefully the increase in the yield will offset that pullback.

Joel: And the NAV is the net asset value, or the value of your bond fund. And that’s an important point because you were saying that it’s important to actually be using bond funds for this sort of thing.

Steve: Yes. That’s correct. What I don’t want to see investors do right now is lock in a fixed rate at a very low yield, and when yields go up and pass that rate, they’re going to be stuck with what, at the time, will be a very low yield.

In a rising rate environment, we prefer mutual funds. Funds have the ability to increase their yield as they go through that rate tightening cycle.

Joel: And you talked about duration. What about the types of bonds in the funds?

Steve: Well, you want to focus on investment-grade quality. I think it’s important to avoid right now any kind of junk bonds. Yes, those yields are higher. It can be enticing, but with that comes more risk. Junk bonds have a higher default rate.

Stay investment-grade, stay corporate. Another area where investors want to focus on is domestic. In the wake of the vote in Britain to remove themselves from the European Union, we’ve seen the dollar rally. With a very strong dollar, it favors domestic bonds over international bonds. International bonds are going to see any kind of yield or return get eaten up when they repatriate those foreign currencies back into US dollars.

Joel: With low bond yields, what would you say to investors who want to maybe shave some of their bond portfolio and reach for more yield?

Steve: Sure, it can be enticing looking at the dividends on some stocks. The 0% you’re getting in your bank account right now pales in comparison to maybe a 2% dividend.

Keep in mind though, that that stock is still a stock, so it is going to be volatile, you’re going to have to put up with day-to-day fluctuations. I do like to remind investors, though, that as much as we have to put up with stocks during periods of market weakness, we also have to put up with bonds during periods of low yields.

You want to make sure that you have the right mix of stocks versus bonds, and as long as you do, the ultimate goal is going to be preservation on the bond side; the stocks will provide you the growth.

Steve Giles is vice president and investment advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Jason Scuglik and Peter May

(initially posted July 28, 2016)