Adding Pizzaz to Your Bond Portfolio
Many first-time and veteran investors are comfortable with the reliability and low risk of high-quality bonds. While they may lack the heart-racing excitement of a hot stock on the rise, for those who can live without the thrill and the volatility, there are alternatives to the straight AAA-rated bond-buying rule.
The alternatives listed below may boost returns on various bond types. Also, varying the terms within your bond portfolio and the makeup of the portfolio may boost overall return. Read On!
Single and Loving It
Even if you are very wary of anything but the highest-grade investments and have a strict policy of “AAA-rated only,” you should be aware that there are many good bonds available with an investment-grade rating but with significantly higher yield than some AAA-rated bonds.
For example, in the municipal bond market, Orlando Aviation bonds, are not likely to default, in my opinion, as long as Disney World remains in business. A bond such as this could increase your tax-free yield by half a percentage point or more over most AAA-rated muni bonds. Also, in the taxable bond markets, there are many A-rated bonds from issuers with good credit histories, and they offer a significant yield advantage over AAA-rated corporate bonds.
If you have a portfolio of bonds, you can shift its makeup to boost total yield. Weight your portfolio with a variety of differently rated bonds to boost its overall return without giving up too much creditworthiness. In the segment of the bond portfolio with shorter-term maturities, you may want to consider investing in lower-rated investment-grade bonds, and in the longer-term end of the portfolio maintain the higher-rated investment-grade bonds. In the intermediate-term of the portfolio, mortgage-backed securities, such as GNMAs and FNMAs, which often provide a yield advantage over comparable-term Treasuries, should be considered. However, keep in mind that mortgage-backed securities represent an investment in a pool of mortgage loans; thus, the yield and average life will fluctuate depending on the rate at which mortgage holders prepay the underlying mortgages and changes in interest rates. Your financial advisor should explain how mortgage-backed securites react to different market conditions. In a municipal bond portfolio, total return may be boosted by maintaining the shorter-term bonds in the lower-rated investment-grade municipals and the longer-term bonds in the higher-rated municipals. Also consider housing bonds, a type of municipal bond with a variety of redemption possibilities that generally reward investors with extra return for taking the uncertainty of redemption.
You may want to increase your portfolio’s percentage of long-term bonds (15 to 20 years), up to a maximum of 25% of the bond portfolio. This may provide greater portfolio yield, as long-term yields are generally higher than short-term yields. Remember, you don’t have to hold long-term bonds to maturity. Today’s bond markets are so liquid that many bonds can be easily sold before maturity, perhaps when you feel there will be material change in interest rates, since when interest rates rise, bond prices will fall. Of course, the price you receive on a sale prior to maturity may be higher or lower than what you paid for the bonds.
Consider including a few “cushion” bonds. These are high-coupon bonds (which are bought at a premium) that have very long maturity dates but which have calls in the 5- to 10-year range. If the bond is called, the yield to call will generally be from 0.5 to 1 percentage point higher than the yield to maturity of a comparably rated bond that matures in the year of the call. Because the coupon on the bond is so much higher than current coupons in the market (which is why you pay a premium), the likelihood of the bond being called is very high.
Up the Ladder
Most investors are familiar with the wisdom of having a laddered structure of maturities for their portfolio. Maturities should range from 3 to 12 or 15 years. Rather than selecting bonds that mature in each of those years, purchase bonds of various maturities, types, and yields based on a portfolio divided into segments: short-term of 3 to 7 years; intermediate, 7 to 12 years; and longer-term, 13 years or longer.