In a paradigm of low rates, retirees and others investing in fixed-income funds might want to re-evaluate the trade-offs
While the idea of getting ballast from bonds made sense in decades past, those considering upping their exposure to them through fixed-income funds have a much more complicated decision to make.
The conventional balanced wisdom of putting 40% of one’s portfolio in bonds hasn’t held up that well given the current low-rate environment. As explained by the Wall Street Journal, interest yield on passive bond funds have shrunk to as low as 1.1%, leaving index bond investors with meagre interest coupons and at greater risk from rising rates.
With that in mind, investors might want to weigh other options: spicing up their fixed-income portfolios with funds that fetch higher yield, or ones with varying degrees of rising-rate protection. The current consensus holds that they typical U.S. bond index fund will shed roughly 6% of its price for every percentage-point increase in yields, which would nullify years’ worth of interest receipts.
Speaking to the Journal, Dan Oldroyd, head of target-date strategies at J.P. Morgan Asset Management, took the view that stock valuations are “stretched” to the point where adding risk to the bond bucket is reasonable. Kim DeDominicis, a target-date portfolio manager for T. Rowe, echoed the view, saying certain higher-yielding fixed-income funds can offer higher expected returns and provide rising-rate insulation, with “modest increases to expected volatility.”
Three kinds of fixed-income funds – high-yield bond, emerging-market bond, and floating-rate funds – may be more appealing than the vanilla bond index fund. Work done by Morningstar personal-finance director Christine Benz, in which she constructed a series of retiree investment models, suggests a dedicating 14% to 22% of the fixed-income sleeve to such bonds can “bump up yields and provide extra diversity.”
Interest rates on the three types of funds may provide double or triple the interest rates of a bond index fund; those focused on high yield and emerging markets also often outperform the index over a full market cycle. Over the past decade, funds of both types have performed better than the index, Morningstar data show.
But such investments also come with their own risk. Morningstar has found that compared to the safer index, all three of those categories of fixed-income funds took a bigger beating last year, declining more than 20% in price in contrast to 8.6% for bond index funds. The desire to avoid such swings has motivated certain target-date fund sponsors to avoid those more adventurous flavours of fixed income.