So how can bond investors produce enough income?
One of the most dangerous practices in bond market investing is “reaching for yield,” going outside of your normal parameters in order to produce the income that you need. But extraordinary times call for extraordinary measures, and when circumstances change people need to adapt.
Certainly, the last 5 years have been extraordinary, with the Fed holding its target rate below the inflation rate. Most folks thought that rates would have returned to normal by now. But with the economy still weak and no prospect for higher rates in sight, what can bonds investors do?
One approach is to extend maturities, but that leaves them more vulnerable to rising interest rates. If rates rise 1%, the price a 5-year bond falls about 5%, but a 20-year falls 15%–3 times as much. And these longer bonds only yield 2% more. We call that “return-free risk.”
But by taking controlled credit risk—in a managed, diversified portfolio—investors improve their incomes while only marginally adding to the volatility of their portfolios, because if rates rise now, it will be because the economy is improving—helping lower-rated firms.
Short, lower-rated bonds are a reasonable addition to an income-oriented portfolio. And they can help investors reach their goals.
Douglas R. Tengdin, CFA
Chief Investment Officer
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