If you’re looking for more retirement income, there are reasons to be cheery these days. Buy a 10-year Treasury note and you can scoop up a 2.85% yield — roughly a point higher than a year ago. Corporate bonds offer a bit more interest, and if you can handle the additional risk, "junk" bonds now yield around 6.8%, on average.
Unfortunately, these yields aren't the same as total returns. Bond investors can lose money if interest rates rise. Indeed, as the 10-year Treasury yield jumped from 1.86% to around 3% last year, the U.S. bond market posted a 2% loss, according to the Barclays U.S. Aggregate Bond Index. (Bond prices and yields move in opposite directions).
Most analysts don't expect yields to climb as steeply this year; the Federal Reserve would likely prevent it. But yields aren't likely to fall much, and the 10-year Treasury could edge up to the 3.5% range if the economy continues to strengthen.
"We think bonds will be less bad in 2014, but they'll still see some pressure," says Mitchell Reiner, managing partner at Wela Wealth Strategies, an investment adviser in Atlanta.
Layer in alternative income
Even if rates rise modestly, conventional bonds can help preserve capital and smooth out volatility in a portfolio. But if you need more income — and can handle a bit more volatility — many advisers suggest layering in other income-oriented investments including preferred stocks, REITs, MLPs and closed-end funds.
These investments can help diversify your holdings since they don't all move as closely in line with interest rates. They also tend to offer higher yields than conventional bonds, says Reiner, who recommends these income sources for his clients.
Using ETFs, Reiner suggests the following "yield-plus" portfolio for investors looking to enhance their fixed-income returns:
For further research: Vanguard Total Bond Market ETF (BND); iShares iBoxx Investment Grade Corporate Bond ETF (LQD); iShares iBoxx High Yield Corporate Bond ETF (HYG); PowerShares CEF Income Composite Portfolio (PCEF); Vanguard REIT ETF (VNQ); ETRACS Alerian MLP Infrastructure Index ETN (MLPI); PowerShares Preferred Portfolio ETF (PGX)
Source: Wela Wealth Strategies
The portfolio has a targeted yield of 5% to 7%, Reiner says, and should outperform traditional bonds if rates keep rising. It should be rebalanced periodically to maintain the investment mix, he adds.
Key risks: The portfolio could lose money if rates spike or there's another financial crisis. It's likely to be more volatile than a conventional bond portfolio.
Bonds issued by foreign governments and companies tend to yield a bit more than similar U.S. bonds.
Some of these bonds pose currency risk — hence their higher yields. But many funds hedge currency risk or hold foreign bonds denominated in U.S. dollars. And some studies suggest that adding foreign bonds to a portfolio of U.S. stocks and bonds can reduce its volatility and enhance returns.
"Diversifying into foreign bonds can yield significant gains for U.S. investors," says Edith Liu, a Cornell University assistant finance professor who wrote a paper on the topic in 2012.
According to her research, which analyzed stock and bond returns from 2000 to 2010, investors could have lowered their portfolio risk and boosted "risk-adjusted" returns by including some currency-hedged foreign bonds. Indeed, investors with a large chunk of their portfolio in stocks — say 75% — would have reaped the most diversification benefits from adding foreign bonds, her research found.
Two funds to consider:
- PIMCO Foreign Bond (US Dollar Hedged) (PFODX). Morningstar analyst Karin Anderson recommends the fund for its exposure to foreign government debt. The fund hedges currency risk and has returned an average 8.8% over the past five years, ranking in the top 15% of its category.
Key risks: The fund's 30-day SEC yield is relatively low at 1.4%. Shares could slump in a rising rate climate.
- Templeton Global Bond (TEGBX). Run by two Ph.D managers, the fund takes many active currency and debt positions throughout global markets. It's ranked in the top 18% of foreign bond funds over the past five, returning an average 8.5%. It currently yields around 2%.
Key risks: Returns can be volatile. Shares sold in less than a year are subject to a 1% deferred load.
Convertibles for rising rates
Convertible securities are hybrid investments that pay interest and can be redeemed at maturity like a bond. But they can also be converted to stock, offering exposure to the issuing company's stock without as much risk.
One appeal for investors is that convertibles tend to beat other fixed-income investments when rates are rising. According to research from UBS, rising rates typically coincide with a strong stock market and convertible bonds gain value in these periods. Indeed, convertibles have posted positive returns in most periods when the yield on the 10-year Treasury note rose a percentage point or more, according to UBS.
"Convertibles are one of the only fixed-income asset classes that do well in times of rising rates," says Michael Miller, co-chief investment officer of Wellesley Investment Advisers, a convertible bond investment firm in Wellesley, Mass.
Convertibles jumped 22% over the past year, according to the Barclays U.S. Convertible Bond >$500 million Index, and most analysts don't expect similar gains this year. But adding a small amount to convertibles — say 5% or 10% of a fixed-income portfolio — may help your overall returns.
Two top-ranked convertible funds:
- Fidelity Convertible Securities Fund (FCVSX). The fund uses a barbell approach with a mix of equity-like securities and "busted" convertibles that act more like bonds, according to Morningstar analyst Michelle Canavan Ward. Its 21.6% annualized five-year return ranks in the top 1% of peers.
Key risks: The fund is considerably more volatile than the Morningstar category average and could lose money in a broad market decline.
- AllianzGI Convertible Fund (ANZDX). The managers look for quality companies that are beating expectations and improving their balance sheets. Though the fund has been slightly more volatile than the category average, it has outperformed 95% of peers over the past three years with a 10.4% average return.
Key risks: Stock market declines could saddle the fund with losses.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.