How to Mix it Up With Top-Notch Bonds

The science, art — or some would say just plain voodoo — of finding the right portfolio mix is not unlike hitting the local bookstore and heading for the “diet” section. Whether the tome recommends eating like a wise man, he-man or caveman, every author claims to have found the magic elixir (which sadly, looks nothing like a milkshake).

So it goes with finding the right recipe for bonds to place in a portfolio. For while the word “bond” may conjure images of Aunt Bessie handing over a U.S. savings bond with all the earning power of a prune, the truth is that these investments come in as many flavors as there are allocation recipes. And trying to find those ideal bonds, let alone the ideal blend, can prove one heck of a daunting task for an investor.

In fact, you could just chuck the gustatory metaphor — for some of these investing constructs that balance bonds and stocks get downright scientific. Just listen to Marc Rappaport, CEO at DCM Advisors, explain the company’s Centaur fund.

[See: 10 of the Best Stocks to Buy for 2019.]

Says Rappaport: “By investing in both asset classes — the volatility or standard deviation of the Morningstar balanced fund category known as moderate allocation, for example — investors have historically experienced about half the volatility of 100% stocks (via the) S&P 500 over three-, five-, 10- and 15-year periods.”

Got that?

What’s more, the timing for investing in bonds may prove optimal, given the inevitability of change.

“As this 10-year bull rally starts to slow, it could be prudent to shift some of your investments to bonds to protect yourself,” says Merlin Rothfeld, an instructor at Online Trading Academy. “Sure, you may not gain as much if the market continues to rally, but you’ll lock in a positive fixed rate of return. If the markets crash and drop 20%, 30% or more, that small positive rate of return that your bonds are bringing in will be huge.”

Now, a brief primer: In general, bonds serve three primary purposes in portfolios: to generate income, preserve principal and dampen the volatility of other asset classes.

The most crucial difference between a bond buyer and a shareholder is this: When you buy stock, you essentially purchase a financial stake of a company — you own a piece of it. But with a corporate bond, you loan money and collect interest payments, just as a bank would, to whichever party issues it.

Perhaps most important, bonds and stocks balance themselves out by their very nature.

“In general, bonds offer greater stability and lower downside than equities,” says Michael DePalma, portfolio manager of the High Yield Exchange-Traded Fund and managing director at MacKay Shields in New York City. “In addition, risk and returns of bonds are often driven by different factors than stocks, so the returns over time have low correlation to stocks.”

If security is your thing, take a closer look at U.S. Treasury bonds. Treasurys are universally considered battleship-safe investments, though they do have an inverse relationship to Federal Reserve interest rates — falling in yield as interest rates rise.

And yet, some say the Fed is at present mulling an interest rate cut, a stunning reversal of direction considering the signals it gave just a few months ago and the seven interest rate hikes that dominated 2017 and 2018.

And in case you’re in the mood to try something a little more Vegas, consider junk bonds. These corporate bonds can boast a generous interest rates to those who invest but beware, high roller: The companies that issue them are in somewhat shaky condition.

“Lower credit quality bonds — high-yield corporates, for example — generally offer higher returns over time,” says Matthew Diczok, head of fixed-income strategy at Merrill and Bank of America Private Bank. “But they can also exhibit steep losses in any given year and tend to move in the same direction as stocks, lowering portfolio diversification.”

[See: 6 Great Tips to Build an Income-Producing Portfolio.]

If you’re open to spanning the globe, “The bond portfolio should be diversified from a sector, geographic, and maturity perspective,” says Mayra Rodriguez Valladares, managing principal at MRV Associates, and a bank regulatory and capital markets consultant based in New York City.

Specifically, “It should contain a variety of foreign sovereign, corporate, and municipal bonds as well as domestic ones in those categories,” Rodriguez Valladares says. “I also think it’s important to invest in bonds from multilateral issuers such as the Inter-American Development Bank [focused on Latin America and the Caribbean] or World Bank. They’re almost always rated AAA.”

Another major determinant of bond mix centers on just where an investor stands vis-à-vis retirement.

“The prevailing rule of thumb has been that he ideal asset allocation for maximizing portfolio sustainability is around 60% stocks and 40% bonds,” says John H. Robinson, co-founder at Nest Egg Guru and based in Honolulu. But given the current low-interest environment — so long as it lasts — “this classic allocation is more vulnerable to portfolio depletion and lower remaining balances for heirs.”

Thus a better formulation to balance major stock market declines in early retirement with longevity risk, Robinson says, “is more like 70-30 to 80-20.”

And of course, the whole question of whether an investor needs to buy bonds in the first place is open to debate.

“We wouldn’t dissuade anyone from building a strong portfolio without bonds,” Rappaport says. That noted: “We take ‘strong’ to mean ‘sensible’ and a portfolio diversifying investors between these two major asset classes is sound.”

He also cites research from Ibboton & Associates “that supports a balanced portfolio of stocks and bonds for moderate risk investors and our own insight is in line with this.”

[See: Stop Believing These 7 Investing Myths.]

And in a neat trick of investment aplomb, bonds can turn into stocks and still remain bonds, thanks to interest payments.

“Bonds have provided a consistent level of income to a portfolio and this is important because the income is what can be reinvested, or reallocated, in the asset allocation,” says Gregory Hahn, chief investment officer of Indianapolis-based Sanctuary Wealth Partners. “In 1997, a 10-year investment grade security provided a yield of 7.5%, producing meaningful income to reinvest in the portfolio.”

How you reinvest or spend the interest payments is up to you: It all depends on your firm commitment to solid bonds.

More from U.S. News

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7 Best Corporate Bonds to Buy and Hold for 2019

How to Mix it Up With Top-Notch Bonds originally appeared on usnews.com

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