For years I have held several bond funds, from corporate to high yield and international bonds, and I have been fairly satisfied with that low risk, low return portion of the portfolio.
As mentioned in a previous post, I am re-evaluating my allocation to bonds and bond funds, but I have also been experimenting with buying bonds directly rather than funds. It has been an interesting experience, and I thought it would be worth recapping a few points below.
- High Yield Bonds. For years I have owned the Vanguard High Yield bond fund, which is probably the lowest cost high yield fund out there. Earlier this year, I reduced my allocation in high yield bonds, primarily because they tend to correlate more to the stock market than the bond market. Since my objective to buying bonds is to diversify from the stock market, that kind of defeats the purpose. However, as rates have fallen further and further, I decided to switch some of my corporate low-yield bond allocation to high yield, and take control of buying the bonds myself. The hope is I can get a little higher yield than just regular bonds, thus keeping the correlation with the stock market lower. High yield bond funds typically have a huge allocation to energy stocks, which in this environment I also want to stay away from. So I have been building a portfolio of reasonable quality short term maturities that are technically high yield, but I expect will behave more like bonds. I have bought bonds issued by companies such as T-Mobile, Netflix, Best Buy, and Lennar Corp which I feel pretty comfortable owning. Of course, I sacrifice yield for this, but I do feel better owning bonds in companies I understand.
- TIPS. I can’t do a post on bonds without mentioning TIPS – Treasury Inflation protected securities. TIPS are issued by the Federal government and the interest rate is pegged to the inflation rate. These rates naturally are very low.. but then what isn’t? My recommendation for anybody considering TIPs is to make sure and buy I-Bonds from treasurydirect.gov first. The government limits the purchase of I-Bonds to $10,000 per Social security number. The current composite rate for I-Bonds is 1.06% which in most worlds is terrible. However, you can withdraw them penalty free after 5 years (so effectively a 5 year maturity), plus you get inflation protection. In past years there has been a fixed component to the rate, so it was even a better deal, but the current rate is still above a 5 year CD rate, and if inflation increases, you will do even better. And you know the Fed is trying everything it can to increase inflation.
- Foreign Bonds. I have foreign bond funds, and I was considering starting to allocate to owning individual foreign bonds. So I started by looking at the holdings in the Vanguard Emerging Market Bond ETF. This fund has a yield of 3.89%, which is nice in this environment. However, the average maturity is pretty high at 13+ years, which is way longer than I would typically buy a bond for (who knows what he world will look like in 13 years?). It then occurred to me that I have no strong feeling about which countries are over or under priced. I also looked at the market value they had listed for some of their bonds, and looked at the price I could buy the bond for, and in most cases their listed price was about 1% cheaper than I can buy the bond for. I am pretty leery about bond spreads, especially when rates are so low – a 1% spread is in many cases one years worth of interest. So for now, I think I will continue to buy foreign bonds thru funds, as I don’t think I can outperform the experts by 1%.
My foray into holding individual bonds has been interesting, and it makes me feel better when I understand what I own. That is probably the biggest benefit to buying bonds outright. Even if I was a bond wizard I don’t think I can win big holding bonds vs funds. The biggest benefit is probably education and learning about how the bond market works.
