Bonds are generally issued at par, redeemed at par, and along the way they fluctuate in value as prevailing interest rates change. Their total performance closely tracks inflation expectations. So real growth--if any--is too small to be meaningful. Investors often view them as safe, but the volatility of long-term bonds might be as high as that of stocks, while their return per unit of risk is anemic in comparison. To include insult to injury, long-term bonds have a high correlation to other financial assets, and they perform abysmally during periods of high inflation.
Overall, the characteristics of bonds as a tool class are so dismal that you might wonder why any investor will need them at all. Obviously, not all investors have similar needs. Many institutions tend to be more enthusiastic about matching future liabilities with assets than maximizing total return. As an example, life insurance companies can estimate their future liabilities with some precision. Having bonds that mature on schedule allows them to match assets with expected requirements. Statutory regulations require them to carry bonds to back up their obligations. To oversimplify, insurance companies mark up the expense of providing benefits to compute their premiums. Total return isn't as important while the spread. invest in premium bonds
That's not the problem we face as individual investors, though. We want to maximize our return per unit of risk, and bonds don't easily fit in very well. When we plot the risk/reward points for many well-known long-term bond indexes from 1978 to 1997, we see that they all fall far below the conventional risk-reward line. Not really a pretty sight, could it be?
Within the 20-year period, various classes of bonds all land well below the risk-reward line between T-bills and the S&P 500 index.
Bonds have only two useful roles to play inside our asset allocation plans: They can reduce risk to tolerable levels in a portfolio, and they could provide a repository of value to fund future expected cash-flow needs. Obviously, we don't expect the bond percentage of the portfolio to become a dead drag on its overall performance. It makes sense to take prudent steps to enhance returns atlanta divorce attorneys percentage of the portfolio. Let's take a peek at a few of the common methods employed by fixed-income investors to see if any might advance that goal.
Junk Bonds
Investors undertake more risk if they invest in lower-quality bonds. While they could increase total return because they move from government bonds to corporate to high-yield (junk), investors simply don't receive money enough to justify the risk. They remain hopelessly mired below the risk-reward line.
Active Trading
All of us realize that the capital value of a relationship whipsaws as interest rates in the economy change. So, if we had an accurate interest-rate forecast, we will develop a trading strategy to reap capital gains. Buying long-term bonds before interest-rate declines will produce gratifying profits. Pretty simple, huh? The difficulty is, accurate interest-rate forecasts are elusive. Seventy percent of professional economists routinely fail to predict the proper direction of rate movements, aside from their magnitude.
Individual bond selection suffers from the same problems as equity selection. Industry is efficient, and finding enough mispriced bonds to make the effort worthwhile is problematic. It shouldn't surprise us that traditional active management of bond portfolios fails every bit as profoundly as does active equity management.
Riding Down the Yield Curve
Borrowers generally demand additional return for holding longer-maturity bonds. The connection between maturity and return is expressed while the yield curve. When longer-maturity bonds have higher yields, which is a lot of the time, the yield curve is considered positive. As you can see in the graph below, yield typically rises very gradually, while risk will be taking off sharply beyond a one-year maturity. On a risk/reward basis, bonds with maturities in excess of five years are usually not attractive at all. Hence, investors are well advised to confine themselves to the short end of the spectrum.
As a bond's maturity increases, the slope of the danger line is significantly steeper than the slope of the return line.
However, an easy passive technique that I call "riding down the yield curve" can improve yields at the short end of the curve. If the yield curve is positive, simply purchase bonds at an optimum point where interest rates are high, hold them until an optimum point to market at a lesser rate. This captures both the yield on the bond whilst it is held, and a capital gain on the difference in price. Through the few occasions when the yield curve is not positive, simply hold short-term bonds. Nothing is lost since the rates are higher here anyway. While the procedure involves trading, it doesn't require any type of forecast to be effective. The yield curve is simply examined daily to determine optimum buying and selling points. To be effective on an after-trading-costs basis, only the most liquid bonds (U.S. Treasury and high-quality corporate bonds) may be used. Over time, a relationship portfolio by having an average duration of only 2 yrs may be enhanced by 1.25% employing this technique.
Foreign Bonds
Theoretically, at the least, the greatest reason for yield differences between foreign and domestic bonds is currency risk. If you were to completely hedge currency risk, you should theoretically be back at the T-bill rate. But in actual life, opportunities exist to get short-term foreign-government bonds, hedge away the currency risk, and still have an increased yield. Benefiting from these "targets of opportunity" can further enhance a short-term bond portfolio, perhaps by a portion point or two. Obviously, if you can find no such opportunities during a specific period, just buy domestic bonds.
No comments:
Post a Comment