Bonds

Bonds are a challenge for many DIY investors.  DIY investors go through the asset allocation process, perhaps by using one of the many asset allocator tools on line, and end up facing a percentage - 30% bonds.

Now what?


In times past, with yields at more normal levels, the DIY investor could buy a total bond market ETF indexed against the Barclay's Aggregate Index, such as AGG or BND, and be done.  The Aggregate Index is matched versus the entire bond market with maturities exceeding one year.  It includes Treasuries, Corporates, Agencies and Mortgage-Backed Securi ties. It is the bond market's equivalent of the S&P 500 in stocks.  In the past, these various parts of the bond market would have offered what was viewed as decent yields (more on this below).

If the DIY investor wanted some background on bonds, he or she could go to a book like The Strategic Bond Investor: Strategies and Tools to Unlock the Power of the Bond Market or a website like investinginbonds.com.

Today,; yields are near historically low levels but there are more opportunities to explore.  The DIY investor can invest, for example,  in  an ETF that indexes the high-yield market like JNK, or an ETF that is indexed to shorter maturity corporates like CSJ.  Moving away from the basic bond market, there are Master Limited Partnership ETFs, like AMLP, or even a trust preferred stock ETF like PFF .

With this bewildering array of choices, how should the DIY investor respond?  First of all, it is important to always remember that, to get incremental yield, you take on additional risk.  This is a fact of life in the world of investing.  Thus, even though you are diversified among issues by investing in ETFs, it is important to diversify among investment types.

My approach is typically as follows.  Suppose an investor has $1.0 million and the allocation model comes up with the 30% bond allocation as mentioned above.  Then the DIYer is targeting $300,000 initially to bonds (or fixed income).  Many times I would recommend 50% of this allocation, i.e. $150,000,  invested in AGG or BND.  Then I would put $15,000 in the other parts of the bond market like JNK and AMLP.  I would put 10% in CSJ, etc., even though the bonds in CSJ are already in AGG.  The reason here is that I am recommending a shorter overall maturity posture in the bond market on the belief that yields are likely to rise.

Are Yields Attractive?

DIY investors sometimes have difficulty thinking in terms of real yields.  The real yield is basically the difference between the nominal yield and the rate of inflation.  Simply, if we get a yield of 3% for one year and inflation is 1%, then the real yield is 2%.

In the early 1980s, yields were double digits as was inflation. In fact, for much of the period, real yields were negative, meaning that funds invested at these rates could buy less after a year than at the beginning of the year - even with the earned interest.

From this perspective, yields do not look horrible today.  The key, however, is to keep an eye on inflation.