Back in the summer, fears that the government might soon start tapering economic stimulus triggered a bond sell-off. Now, many investors who dumped bonds and put that cash into money market accounts are still earning nearly nothing.
Compared with those returns, fixed-income investments earning low single-digit returns are quite attractive.
Many of these investors are looking to get back into fixed income investments, but they're concerned that the bond market could be roiled again when the Fed takes it foot off the stimulus gas pedal.
If you're getting back into bonds – or adjusting or establishing a diversified investment portfolio with a bond component – this is a time to think outside the conventional bond box, beyond owning individual investment-grade corporate bonds and Treasuries. Instead, you might want to consider bond-related substitutes that can deliver income while providing far more flexibility than bonds themselves.
Interest rates have been historically rock-bottom low in recent years, and if they rise, you don't want to be holding long-term bonds or other long-term fixed-income investments. When higher rates are accompanied by rising inflation, this means two things: That if you hold on to long-term bonds until maturity, you may receive returns lower than inflation and thus, the buying power of the money invested will have decreased, defeating the purpose of buying the bond.
If you want to sell before the bond matures, you may have to take a loss. So the key is to build or adjust your bond portfolio with flexibility in mind, looking for liquidity potential – the ability to get out without pain.
The possibility of another government-shutdown/debt ceiling crisis in Congress introduces uncertainty and near-term risk, making flexibility in your fixed-income holdings all the more critical.
Consider these alternatives to owning individual investment-grade corporate bonds and run-of-the-mill Treasuries:
• Exchange Traded Funds (ETFs) that invest in different types of bonds. By buying shares in these flexible bond index funds, you can own a share of a diversified portfolio of bonds without being locked into set maturities since the fund can own hundreds of bonds with different maturities. Unlike bond mutual funds, shares of ETFs are traded on exchanges throughout the trading day, so you can sell any time during the trading day.
With most bond mutual funds, you can't sell until the end of the trading day, so if things are going south, you must sit there and take the pain. Not so with ETFs. An example of such ETFs is the iShares Core Total Aggregate US Bond ETF (AGG). As with stocks, you can buy ETFs using a price limit, saying "here's the most I'm willing to pay" and then letting that limit stand.
• Floating rate bond funds. These funds track bonds with variable rates based on underlying indexes that are widely followed. Though the rates of these bonds aren't fixed, they are less sensitive to the forces that tend to punish fixed-income investments, so they can be used to hedge against rising interest rates. However, it's important to keep in mind that continued low rates in the overall bond market could keep floating rates generally depressed for years.
To stay flexible and manage such risks, consider ETFs in this category; you can get out whenever you like. Examples include SPDR Barclays Capital Investment Grade Floating Rate (FLRN) and Market Vectors Investment Grade Floating Rate Bond ETF (FLTR).
• Floating rate Treasuries. The US government this month announced plans to sell floating rate Treasury bonds. Of course, investing in this debt directly – rather than through a fund can be more time consuming.
• Convertible bonds. These are bonds that the investor can convert into shares of the issuing company's stock at certain times – essentially, a bond with a stock option inside. In return for this flexibility and risk reduction – afforded by the option to convert to stock when the price is high, netting gains -- the buyer tends to get lower yields. Because of the conversion option, convertibles tend to rise in value with the associated stock price. A broad spectrum of convertibles can be accessed by buying shares in convertible bond funds or in exchange-traded funds that own convertibles.
• Senior bank loans. These are investments pegged to bank financing arrangements in which the lender has the first (or senior) claim on the borrower's assets as collateral. They carry a bit more risk than most corporate bonds, but the higher yield can sometimes the extra risk. Depending on how you're structuring your fixed-income portfolio, these can play a role. For most investors, again, an ETF based on these investments is more appropriate, as they are a quick route to diversification. Examples include the Power Shares Senior Loan Portfolio, SPDR Blackstone/GSO Senior Loan ETF and Highland iBoxx Senior Loan.
With all of these ETFs, you can set stop-loss limit to halt sliding values promptly if the market gets bumpy and move to the sidelines in the middle of the trading day. By the same token, you can also set a limit when you buy – which could be especially helpful regarding ETFs that don't trade that many shares on a daily basis.
One factor that spurred the bond sell-off last summer was uncertainty over who the next Federal Reserve chairman was going to be. Now there's more stability because the president's nominee, Janet Yellen , if confirmed, is viewed as likely to continue the stimulus policies of outgoing the outgoing chairman, Ben Bernanke, so fears that the government will begin tapering stimulus in the near term have abated.
Whether any of these type of bond-related substitutes are appropriate for your portfolio depends on many factors – such as your risk tolerance, time horizon, and investment objectives just to name a few. But, if you're sitting on a lot of cash earning next to nothing, you might want to consider doing some more research to see if any are are right for you.
Given the economic uncertainty that lies ahead – the more flexible among these fixed-income investments mighht help manage risk effectively. Their liquidity allows you to quickly move holdings to cash islands like money market funds if an economic storm threatens their value.
Disclosure: As of this writing, I held positions in the SPDR Barclays Capital Convertible ETF (CWB) and the PowerShares Senior Loan Portfolio ETF (BKLN). No statement in this article should be interpreted as a recommendation to purchase any of the investments mentioned.
This column is the opinion of the author and in no way reflects the opinion of ABC News.
Byron L. Studdard, a CERTIFIED FINANCIAL PLANNER™ practitioner, is founder and president of Studdard Financial, LLC, a financial advisory firm in Sarasota, Fla., dedicated to helping clients build wealth, protect it and pass it on to future generations. Studdard is listed in the Guide to America's Best Financial Planners (published by the Consumers' Research Council of America, an independent research organization). He can be reached at Byron@studdardfinancial.com. If you have a question for him, send him an email and he will try to answer it in an upcoming column.