There are generally a couple of reasons to include bonds in accounts.
First, they provide some ballast if the equities markets turn south. Except for some kind of negative credit event, bonds will mature when due, regardless of what else is going on in the world, and investors will have their capital returned.
And, second, bonds usually offer a little income.
Unfortunately, with yields at such miniscule levels, the income return from bonds is paltry. In the case of high quality bonds - such as U.S. Treasury obligations - today's yields are barely keeping up with inflation.
In recent meetings, I have encountered three different opinions on how best to manage a bond portfolio in today's environment.
The first is essentially to "stay the course". In the case of institutional portfolios, this means to manage accounts against a widely-accepted benchmark such as the Barclay Government/Credit bond index. This has been the strategy for most bond managers since the early 1980's.
The problem with this approach is that you can experience negative total returns for an extended period of time if interest rates move higher.
The Barclays index, for example, has a duration of nearly 4 years. Roughly speaking, this means that if interest rates move 100 basis points higher than today's levels, the value of the bond portfolio will drop by -4%, or more than the income being generated by the bonds in the account.
The second approach is to move lower in credit quality. This is approach that has adopted by a growing number of investors who are ignoring credit risk and simply buying the highest yields they can find.
Not only are assets like high yield bonds benefiting from this trend, but also some unusual issuers that in "normal" times would not have received much interest.
Two weeks ago the government of Rwanda - the same desperately poor country whose genocide was the subject of the award-winning Hotel Rwanda two decades ago - was able to issue bonds with a 6.875% coupon.
Here's an excerpt from an article Reuters published last Friday:
Latest was Rwanda, still recovering from the 1994 genocide. Orders for the East African country's debut dollar bond last week reached $3.5 billion, more than 8 times the bond's issue size.
"In a market where you constantly get burnt trading fundamentals, traders are going to the other extreme, ignoring fundamentals and just looking for yield," said Manik Narain, emerging markets strategist at UBS.
"It's really reaching bubble-like proportions."
Single-B rated Rwanda issued dollar debt at a yield of 6.875 percent, paying not much more than euro zone member Slovenia, which issued 10-year debt on Thursday at 6 percent.
Rwanda's yield is below the 7 percent threshold which investment grade-rated Spain briefly breached last July, before the European Central Bank's OMT bond-buying plan helped to dampen yields.
http://www.reuters.com/article/2013/05/03/us-frontier-debt-idUSBRE94208O20130503
I am convinced that years from now investors will look back to crazed demand for yield with the same sense of bewilderment and wonder that we now view the dot com stock bubble of the late 1990's.
Sufficient to say that I am not a fan of low quality bonds here.
The third approach to bonds in a balanced portfolio is to reduce interest rate exposure and move higher in quality. The idea here is that it seems pointless to take extreme interest rate or credit risk positions for just a few more basis points of return.
Instead, by populating a bond portfolio with high quality issues maturing in 2 years or less investors are at least achieving one of the goals of including bonds in a balanced portfolio - capital stability.
Put another way, this may be one of those frustrating times when patience, and not greed, should be the watchword for investors.
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