Financial Planning Focus - With Yields Rising, Why Buy Bonds?
At West Financial, we believe that fixed income is an integral part of a balanced and diversified portfolio. Within the fixed income allocation, our primary focus is to purchase individual bonds for capital preservation, with income as a secondary consideration. Having an allocation to fixed income can decrease volatility in your portfolio returns and can cushion shocks felt through the equity markets when they occur.
We diversify our fixed income by sector (financials, health care, etc.) and do not concentrate holdings in any one company. Our goal is to hold a bond to maturity, knowing the client will receive income through interest payments, and the proceeds of the bond at maturity. We are able to stagger maturities (bond ladder) so that principal will be available for cash needs, such as required minimum distributions in IRAs, real estate down payments, tuition, etc. By building a bond ladder, we continually have bonds maturing to take advantage of any increase in interest rates, and also obtain additional yield by purchasing longer bonds at the top of the ladder.
Currently, corporate and municipal bonds offer more attractive yields than Treasuries, agency securities and CDs. The yield curves for both corporate and municipal bonds, although not exact, track the flattening path of Treasury yields. For corporate bonds the curve flattens out at approximately 8 years, which is the “top” of our bond ladder. As appropriate for the client, we purchase municipal bonds when taxable equivalent yields are attractive. The tax-equivalent yield is what a taxable bond needs to yield pretax for it to be equal to that of a taxfree municipal bond.
Overall, the average maturity for bonds held in client accounts at West Financial is 4.3 years. The average yield to maturity is 2.99%, including municipal bonds which are lower yielding due to their tax-free income status. The duration, or measure of interest rate sensitivity, is 3.75. The duration number implies that, should interest rates increase by 1%, our fixed income portfolio is expected to fall in value by 3.75%. Keep in mind the loss is not realized if the bonds are held to maturity.
We consistently monitor our bonds for price changes and credit rating changes. Our custodians also let us know of any rating changes regarding the fixed income we hold in client portfolios. The majority of our bond purchases have been investment grade (BBB- or better) corporate bonds, with an average credit rating of BBB. According to the most recent RatingsDirect (2016) from S&P Global Ratings, the default rate for the ‘BB’ category in 2016 hit its highest point (0.47%) since 2010. And, for the fifth year in a row, there were no defaults by companies with investment-grade ratings.
Are yields low? Yes, but there are a few broad reasons why yields are so low today. The main one from our vantage point is that demand for bonds is strong, pushing prices higher and yields lower. Central banks have been buying bonds since the Fed’s first QE program in November 2008.
Another factor helping to keep U.S. bond yields low is the low yields in other countries. Low global yields are driving purchases of U.S. bonds worldwide. Recently, we saw the following rates per Bloomberg Markets:
- The yield on a 10-year U.S. Treasury was 2.95 percent.
- Germany’s 10-year yield was 0.56 percent.
- Japan’s 10-year yield was 0.03 percent.
So, while yields are admittedly low, we believe that fixed income provides a combination of stable income and low price volatility in any market. With the stock market exhibiting large day-to-day point changes, stability, lower volatility and income can be very attractive.