AAII Journal Editor
Managing Bond Risk
A bond ladder can reduce the risk of interest rate uncertainty.
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Many members are discussing their bond strategies.
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Inflation and speculation about what the Fed’s next move will be are prominent in headlines about the bond market, but there are also scattered reports that show an increased tolerance for risk among bond investors.
One recent example is payment-in-kind toggle notes, or PIK toggles. These are notes that allow borrowers to issue additional debt securities in lieu of paying cash for interest payments. In other words, if an issuer does not have the cash for the next coupon payment, bondholders will receive more debt. Think about it as a loan that is being repaid with a promissory note to pay you even more back at a later date. As Dow Jones Newswires reported last week, a $600 million offering from Aramark Holdings Corporation tied for the biggest PIK toggles offering since the start of 2010.
It’s not just PIK notes. A few weeks ago, I sold my shares in PIMCO Corporate Opportunity (PTY) because the high-yield closed-end fund was trading at a 25% premium to its underlying net asset value. I realize this fund operates under the watchful eye of famed bond investor Bill Gross, but a 25% premium is a steep price to pay. Bluntly put, somebody was willing to pay $1.25 per dollar of assets just to own a high-yield fund. (A quick side note: If you invest in closed-end funds, pay attention to the net asset value (NAV) before you buy the fund and while you own it.)
These events follow anecdotal reports I saw last year about issuers trying to ease the covenants, or loan requirements, placed in their debt offerings. The inherent problem with viewing scattered reports and data is that they can lead to a misperception of what is actually occurring. To confirm my viewpoints on the bond markets, I called Guy LeBas, the chief fixed-income strategist at Janney Montgomery Scott.
Guy told me that the demand for high-yield debt is a function of the improving economy, declining returns for the debt market, and the fact that the weakest issuers were effectively shaken out by the last recession. He further pointed out that some bond investors are viewing credit risk (the chances of a company defaulting on its debt) as less of a concern than interest rate risk (the chances of interest rates rising).
The trade-off between higher portfolio income and wealth preservation is one that many AAII members face. Substituting dividend-yielding stocks for bonds doesn’t solve this problem, because a correction or a bear market will drag down dividend-yielding stocks. Suffice it to say, those of you who depend on portfolio income don’t have great options to choose from. (Believe me, I wish could I tell you otherwise.)
The best strategy is simply to diversify your bond holdings while paying attention to the quality of what you are investing in. Seek out bonds, both government and corporate, with varying maturity dates and yields. Also, consider using funds to get overseas fixed-income exposure. Most importantly, just realize that, although the uncertainty about future interest rates is disconcerting, no one knows with certainty when the Federal Reserve will start to raise rates or by how much.
Get to Know Bond Ladders
An effective way of managing a fixed-income portfolio for an uncertain interest rate environment is to ladder bonds. The terminology refers to combining bonds with different maturity dates within the same portfolio. This allows you to maintain an exposure to bonds and remove the risk of incorrectly timing the market. As bonds mature, you simply reinvest the proceeds into new bonds at the then-prevailing interest rates.
Steven Bohlin explained how to create a bond ladder in this 2004 AAII Journal article.
If you own fixed-income funds instead of individual bonds, you won’t be able to build a true ladder. What you could do, however, is combine funds with different durations. Since duration is a measure of interest rate sensitivity, one easy way to go about this is to look for a mixture of short-term, intermediate-term and long-term bond funds.
What to do about bonds has been an ongoing topic of conversation for many AAII members, as these posts to our discussion board show.
The Week Ahead
AAII President John Bajkowski, Computerized Investing Editor Wayne Thorp and myself will be visiting local AAII chapters next week. Click on the chapter name for more details.
- Southeast Florida: John will speak in Delray Beach on Tuesday and in Fort Lauderdale on Wednesday about “Finding a Stock Winner: First Step Screening.”
- Florida West Coast: Wayne will speak in St. Petersburg on Tuesday about “Computerized Stock Screening & Analysis.”
- Central Florida: Wayne will speak in Winter Park on Wednesday about “Computerized Stock Screening & Analysis.”
- Southwest Florida: Wayne will speak in Venice and Sarasota on Thursday about “Computerized Stock Screening & Analysis.”
- Eastern Michigan: I will speak in Troy on Thursday about “How to Get Lucky With Your Portfolio.”
Information about all upcoming local chapter meetings can be found on AAII.com.
Approximately 100 members of the S&P 500 will report first-quarter earnings next week. Included in this group are several Dow components. Intel (INTC) and Johnson & Johnson (JNJ) will report on Tuesday, American Express (AXP) and United Technologies (UTX) are scheduled for Wednesday, and DuPont (DD), General Electric (GE), McDonald’s (MCD), Travelers (TRV) and Verizon (VZ) will announce their results on Thursday.
The week’s first economic report will be the April National Association of Home Builders (NAHB) housing market index, which will be published on Monday. Tuesday will feature March housing starts and building permits. March existing home sales will be released on Wednesday. Thursday will feature the April Philadelphia Federal Reserve manufacturing survey and the Conference Board’s March leading indicator index.
Volume could be lighter than we’ve been seeing on Monday afternoon because Passover starts at sundown. (Happy Pesach!) The U.S. financial markets will be closed on Friday in observance of Good Friday.
Taxes are due Monday by midnight.
AAII Sentiment Survey
This week’s AAII Sentiment Survey results:
Bullish: 42.2%, down 1.4 points
Neutral: 26.8%, down 0.8 points
Bearish: 31.0%, up 2.1 points
Bullish sentiment slipped 1.4 percentage points to 42.2% in the latest AAII sentiment survey. Optimism that stock prices will rise over the next six months stayed within a two percentage point range for the third consecutive week. The historical average is 39%.
Neutral sentiment, expectations that stock prices will stay essentially flat over the next six months, edged down 0.8% to 26.8%. This is a nine-week low for neutral sentiment. The historical average is 31%.
Bearish sentiment, expectations that stock prices will fall over the next six months, rose 2.1 percentage points to 31.0%. The historical average is 30%.
Individual investors remain optimistic about the short-term direction for stock prices, although cautiously so. Bearish sentiment received a boost from last week’s federal budget battle and a small decline in stock prices, but both optimism and pessimism remain near their historical averages. Corporate earnings, a rebounding economy and the stock market’s rally are giving individual investors hope, while the sluggish labor market and global events are keeping them from being overly sanguine.
This week’s special question asked AAII members about their longer-term view. Specifically, they were asked whether there was more potential upside or downside for stocks over the next 12 to 24 months. Respondents were divided, with slightly more anticipating a further rise in stocks prices than those who thought stock prices will fall. A small number thought stocks would fluctuate and not show big gains or losses.
Here is a sampling of the responses:
- “Our recovery is still in the early stages. The potential for stocks is positive.”
- “There is more potential for gains over the next 12-24 months as the economy gains steam.”
- “We are in a secular bear market, and I foresee a huge downside for stocks.”
- “I think there is more potential downside for stocks. I base this on the Middle East conflicts and the current presidential administration’s economic policies.”
- “I anticipate a volatile market where selectivity will be important.”
Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.