Why bond balance is so important

Getting the mix and match right is a true balancing act.

  • By Lou Carlozo,
  • U.S. News & World Report
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Here's the thing about bonds: They're not as glamorous as stocks by a long shot. The glorious rise of Amazon.com (AMZN) and the gory struggles of General Electric Co. (GE) boast a lot more storytelling arc than, say, crunching the micro-digits of a U.S. Treasury bond – which will never make headlines except in the unlikely event that the government paints a fleet of sailboats to promote them.

"It's true, bonds are not going to be the jaw-dropping conversation starter as bitcoin or cannabis stocks these days," says Matthew Miskin, market strategist at John Hancock Investments and based in the Boston area. "But after bonds were nearly left for dead in the third quarter of last year, they re-emerged in the fourth quarter to be a vital part of investment portfolios."

Miskin adds: "They turned out to be of the best performing asset classes in the world amidst the global market meltdown to end 2018."

Here it must be pointed out that even Warren Buffett took a huge hit on stocks at year's end, particularly Kraft Heinz Co. (KHC). Assuming he had put some of his money in bonds instead, he'd be better off in the billions – at least in the short term.

The bottom line? Just as the ballast keeps proud sails from tipping into rough seas, so too do bonds keep a portfolio from capsizing. The question, though, is to what extent investors should go for the bonds. And there, it turns out, absolutes simply cannot apply – though the compass points some sure ways to safe harbors.

"While stocks garner the most attention in portfolios today, bonds are just as important as they offer diversification benefits and potential safety in times of uncertain economic and market environments," says Gene F. Goldman, chief investment officer and director of research at Cetera Investment Management and based in El Segundo, California.

Yet outside of defensive reasons, "There are reasons to hold bonds," Goldman says. "Slowing economic growth is a positive factor as weaker growth suggests less inflationary pressures – which can be detrimental to bond prices." He also points to how U.S. bond yields are relatively higher than in most countries. Hence, "International bond buyers continue to buy long-dated U.S. bonds for income."

Getting more granular on the homefront, "Consider high quality bonds – A-rated or better – issued by large domestic banks," says Seth Hieken, executive vice president and director of proprietary strategies for The Colony Group in Boston. The regulatory restrictions following the 2008 financial crisis boosted the capital banks carry. "That makes their bonds generally much safer investments."

And yet, this hardly means all bonds function alike. Hieken points to purchasing power risk, based on how inflation erodes real portfolio value: "An investor today must earn an average after-tax yield of about 2 percent just to break even with the prevailing rate of inflation. For high earning investors, Treasury bonds do not deliver that rate except at very long maturities."

As a strong alternative, "High quality corporate bonds in general are good portfolio choices in any environment," says Jay Sommariva, vice president and director of fixed income at Fort Pitt Capital Group in Pittsburgh. "Having a solid base of high quality corporates is a good way to preserve capital while mostly being able to beat inflation."

There's also the question of what percentage allocations might apply. To that end, Polaris Greystone Financial Group in San Rafael, California ran some test scenarios with stock-bond rations of 70/30, 50/50 and 30/70 respectively. The samples looked at retirees in 1982 (a declining interest rate market) and 1954 (a rising one).

The result? "Stocks and bonds at 70/30 outperformed scenarios in both interest rate environments," says Jeffrey Powell, Polaris Greystone's chief investment officer.

Powell also invokes two colorful terms to characterize the characteristics of certain yield curves. "For 'portfolio stuffers,' I would recommend short-term Treasurys," he says. "And 'ugly bonds' are anything on the long end of the yield curve: The risk/reward simply isn't there."

As Powell points out – and this is crucial – some bonds have higher risk rates than others. Thus the changing tenor of the times highlights the wisdom of shifting strategy within bonds themselves.

"The start of 2019 has been nothing short of amazing for riskier asset classes such as global stocks, small-caps, and high-yield bonds," Miskin says. "However, the underlying economic data has not been as stellar."

He points to "a clear global slowdown that spilled over from the back of 2018. The U.S. is in decent shape, but looking abroad Europe and broader Asia are clearly seeing a slowing economic backdrop. As a result, we would not chase returns of riskier stocks or bonds, for that matter."

But what you chase, or lie in wait for, often breaks down to the waters you want to navigate. Are any two investors alike? You might as well ask whether any two captains would sail the same vessel the same way.

"We prefer to pose a question to our clients first: What do you want your fixed income to do?" says Jack Janasiewicz, senior vice president and portfolio strategist with Natixis' portfolio research and consulting group. "How the client responds to this question frames our approach to what bonds we should look, framing the answer through the lens of asset allocation and portfolio construction."

The Boston-based Janasiewicz also invokes a nautical metaphor. "A client looking for ballast – modest returns but with an eye on limited volatility – should expect to use some investment grade or mortgage backed/securitized securities," he says. "These higher quality bonds still have modest room for price appreciation but tend to exhibit lower volatility, ultimately providing some form of risk reduction and sound diversification."

Diversification. Risk reduction. Higher quality: words for any intrepid market voyager to live by.

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