Over the last few years, diversification has become a dirty word on Wall Street. Amid consistent outperformance for large-cap tech stocks and a steady grind higher for “risk-on” equities in general, many investors have been conditioned to rely on a select group stocks and ignore the rest.
Heck, it’s hard to shake that logic even now. While tech darlings Apple Inc. (AAPL), and Facebook Inc. (FB), are both down approximately 20% in the last three months, a longer-term look shows the pair are leaving the rest of Wall Street in the dust; Apple is up 120% in the last five years vs. just 50% or so for the S&P 500 (.SPX), Facebook stock is up an impressive 190% to lap the S&P almost four times over.
But history shows fashionable investment ideas are rarely durable ones. And as the stock market gets choppy and old favorites show signs of weakness, it’s worth wondering whether it’s time to get back to basics and embrace diversification — both across sectors as well as a cross asset classes.
That means taking a serious look at bonds as we enter 2019.
I know, the pitch for bonds may sound insane to some. After all, the Fed is clearly on a path to a fed-funds rate as growth remains strong and inflation creeps higher, and bond values typically drop as interest rates rise. And furthermore, overall bond yields remain quite anemic from a historic perspective; while many have been gaga over 10-year Treasury yields, edging north of 3%, the average yield on the 10-year over the last 30 years is actually north of 6%.
But investors should not forget that bonds are a crucial tool in a well-rounded portfolio. A few unique bond strategies are actually doing pretty well right now — and perhaps are poised for even bigger success in the New Year.
Here are five tactical bond strategies to round out your portfolio and provide stability in this choppy market.
Unconstrained bond funds
Let’s start with an incredibly unfashionable idea: a mutual fund with above-average fees, actively managing its portfolio. Investors who strongly believe active management is a net negative overall and prefer the rock-bottom fee structure of indexed ETFs may be aghast at this idea, but hear me out.
Index funds are necessarily rigid and that’s a bad strategy in a rising rate environment if you’re on the wrong side of the trade. Just look at mega-funds like the $53 billion iShares Core U.S. Aggregate Bond ETF (AGG), that has lost about 4% in the last 12 months of rate tightening as proof, or the popular iShares 20+ Year Treasury Bond ETF (TLT), which has lost about 9% in the same period.
Unconstrained bond funds have the flexibility to avoid the most troubled parts of the bond market, such as longer-dated U.S. government bonds, and seek out opportunities where they find it.
Take the Guggenheim Macro Opportunities Fund (GIOIX), as a prime example. It has held tough with a decline of less than 2%, all while offering a yield of about 3.5% while both of the aforementioned ETFs offer under 3.0%. That shows the power of an active, unconstrained bond strategy right now, and more than offsets this fund’s comparatively higher fee structure.
Short-term corporate bonds
If you simply can’t stomach this old-school concept, then consider an index fund that is more appropriate for the current environment. Namely, shorten your duration and increase your yield with investment-grade corporate bonds that pay a bit more than T-notes but don’t have the big risks of junk.
There are plenty of funds out there like this, but one of the most popular is the Vanguard Short-Term Corporate Bond ETF (VCSH), an ETF that focuses on investment grade bonds with a duration of 1 to 5 years. We’re talking about loans to megacaps that aren’t likely to default, including Bank of America (BAC), Apple and Verizon (VZ).
The 30-day yield of 3.7 % is much better than that of those popular but under-performing ETFs I flagged earlier, and as is typical for a Vanguard index fund the ETF is dirt cheap at 0.07% in fees or just $7 annually on every $10,000 invested.
Treasury Inflation Protected Securities got a bad rap during the Great Recession. That’s because at times TIPS bonds had sold with negative yields to maturity, since the asset is benchmarked to the Consumer Price Index and the market’s inflation fears were a bit overdone.
But the situation has changed a great deal now that were are roughly a decade removed from the financial crisis. Inflation is up across the board, including higher wages and rents, and data in November showed the Consumer Price Index rising at a 2.5% annual rate. That’s above the Fed’s 2.0% target, and a big reason rates have been creeping higher in the last few years.
If you want to play this near-term inflation trend, then consider funds like the iShares 0-5 Year TIPS Bond ETF (STIP), With shorter-duration TIPS as its holdings, you don’t need to worry about the long-term prospects of inflation and simply can capitalize on the stability of these bonds and the uptrend in current consumer prices. A 30-day yield of 2.5% and the prospect of better returns as inflation rises makes this fund a decent tactical bet if you want to branch out into bonds.
We’ve discussed ways to mitigate interest rate risk via active management and shorter duration, but it’s important to acknowledge that any potential loss in bond principal is only realized if and when bonds are sold. If you hold your bond to maturity, you actually get the face value of the bond back and never have to worry about selling at a discount on the open market.
You can do this through individual bond purchases on your own, but some investors are leery of simply buying and holding a few long-term bonds to maturity. Aside from liquidity concerns, there are also reasons to fret about making an ill-timed purchase in a small number of bonds as rates march higher.
However, “laddering” your bonds by staggering their maturities can help. This strategy involves rolling maturities that allow a few bonds to mature each year, allowing for steady reinvestment to mitigate interest rate risk.
If you like this concept of laddering your bonds in theory but are intimidated by putting the strategy into practice, consider the Invesco LadderRite 0-5 Year Corporate Bond Portfolio (LDRI), as a tool. The fund does have a small amount of turnover — and charges a nominal expense of 0.22% or $22 annually on every $10,000 invested — so the fund isn’t perfectly flat in principal value and is down about 2% in the last 12 months. However, it is much more stable than the popular bond ETFs out there and yields a nice 3.3% at present.
Situational bond funds
Some investors may think the right approach to bonds involves some combination of the strategies above. Others may find the strategies academically interesting as short-term plays, but questionable as long-term holdings. If either of these descriptions include your personal point of view, than allow me to offer up some of the more arcane bond funds out there that are tailor-made for the current moment and rising rate environment.
First, there’s the Sit Rising Rate ETF (RISE), that uses derivatives to bet against long-term Treasury bonds. Think of it as an inverse bond ETF, as evidenced by the fact that this fund has increased in value 5% or so in the last 12 months as the typical diversified bond fund has suffered.
A very different example of a tactical bond fund would be the ProShares Inflation Expectations ETF (RINF), which takes the already stodgy strategy of TIPS and makes it even more of a defensive play — which is quite a feat. This ETF uses swaps to hedge against possible rate declines, and is tailored to a 30-year view on inflation data instead of short-term rate fluctuations to further smooth out volatility. You won’t see much in regards to total return here, with very stable principal values and a modest yield of about 2.8%, but you certainly will have peace of mind.
The challenge of funds like the Sit Rising Rate ETF, and the ProShares Inflation Expectations ETF, is that they necessarily depend on unique conditions and a measure of market timing to provide true out-performance. But if you think the conditions are right in 2019 to use either as a short-term profit center or simply as a hedge, either could help diversify your portfolio away from the typical stock or bond funds you’re used to.
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