Employing Best Practices in Building Bond Portfolios

The world of bonds may seem like a simple place, compared to equities and alternative assets, but it's actually a very complicated asset class. Consider that it includes government bonds, corporate bonds, municipal bonds, high-yield bonds (corporate and municipal), and cash management, as well as the whole other world of foreign sovereign and corporate bonds and Yankee bonds.

Let's look at some of the best practices associated with successfully navigating the world of fixed-income securities.

Building Laddered Bond Portfolios

Because bonds deliver relatively little in the way of return, and are used by investors mainly to produce income and to control portfolio risk, one way to keep bond management costs down is to ladder our fixed-income portfolios. If, for example, we want to build a $1 million bond portfolio with an average maturity of five years, we might simply buy the following bonds:

This gives us a $1 million bond portfolio with an average maturity of five years. Each year, one of our bonds will mature and we will use those proceeds to buy the longest maturity needed to maintain our five-year average maturity. (In 2012, for example, we will use the proceeds of Bond #1 to buy a $100,000 bond maturing in 2022.)

The advantages of this laddered approach are considerable. First, the cost is minuscule, particularly if, as we should, we are using U.S. Treasury notes and bonds.³ Second, because a bond matures every year, we have fairly short liquidity if we should need it. Third, because we are buying bonds over a long period of years, we are averaging in to interest rate changes. Finally, because we are planning to hold each bond until it matures, we can't experience a capital loss in our bond portfolio.

But laddered bond portfolios are not entirely without their complications. In the first place, they should only be used in circumstances where the use of U.S. Treasury securities is appropriate. These securities are the safest paper available and they are not callable. (The U.S. Treasury does, from time to time, attempt to repurchase its notes and bonds on the open market.) Some investors build laddered bond portfolios out of corporate or municipal bonds, but this is dangerous, because many of these securities are callable—defeating the purpose of holding them until maturity and reinvesting at the then-prevailing interest rates—and because nobody is watching the credits of the issuers. (Ah, you say, you plan to confine your fixed-income ladder to the best investment grade bonds. Well, the next time you find yourself thinking along these lines, here is a useful corrective. Repeat to yourself this phrase: “Enron, WorldCom, Global Crossing; Enron, WorldCom, Global Crossing….”)

In the second place, owning a laddered bond portfolio requires iron discipline in not abandoning the ladder in the face of disquieting conditions. In a rising interest rate environment, for example, there will be paper losses in the laddered portfolio and you may be tempted to sell out of some of the bonds and replace them with higher-yielding securities. This will almost surely prove to be a double mistake: You will lock in your loss on the sold bonds and rates will continue to rise on you, causing you to lose money even on your newly purchased bonds.

Similarly, in a declining rate environment your bonds will show gains and you may be tempted to capture those gains before rates rise and they disappear. Again, this is almost certain to prove a foolish strategy: Rates will continue to decline and you will simply be destroying your income stream. In short, the whole thesis underlying laddered fixed-income portfolios is the impossibility of foreseeing the direction or rapidity of interest rate changes or the shape of the yield curve.

Owning Only High-Grade, Noncallable, Long-Term Bonds

Many investors believe that the only fully justifiable excuse for owning bonds—which, after all, impose substantial opportunity costs on portfolios as a result of their low real returns—is as a hedge against the outbreak of deflation. Deflation is a very serious economic condition in which prices actually decline in real terms.⁴ About the only investment assets that will perform well in a deflationary environment are long-term, high-grade, noncallable bonds: for example, 30-year U.S. Treasury bonds.

Actively Managing Municipal Bonds

Most wealthy investors will keep the greatest part of their bond portfolios in municipal bonds, which are (currently, anyway)⁵ free of federal taxation. Unlike Treasury securities and corporate bonds, the municipal bond sector is complex and inefficient, and fairly cries out for competent active management. That said, we have to keep firmly in mind that the municipal sector embraces a particularly unattractive set of issues: It is complex and difficult to succeed in the sector, it is essentially impossible to add wealth to our portfolios no matter how well we do in the sector, and yet the sector represents an essential asset class for most families.

Regarding complexity, consider that the municipal sector includes general obligation (GO) issues floated by all 50 states; issues floated by thousands of cities and towns; issues floated by tens of thousands of special-purpose districts, hospitals, and airports; issues floated by water authorities; prefunding issues; and on and on. The creditworthiness of these many entities is always suspect and is always changing.⁶ There are also odd seasonal issues associated with the municipal sector that must be dealt with, as certain issuers tend to come to market at certain times and as certain large holders of munis tend to liquidate those holdings at certain times. Finally, munis are susceptible to all the interest rate dynamics that bedevil other sectors of the bond markets. In short, individual investors who imagine that they can intelligently assess this world, and then continue to monitor it, are simply kidding themselves.

The best way to manage a substantial municipal bond portfolio is not to give our money to a muni bond manager and hope they do well. Instead, we (and our advisors) should develop a detailed set of objectives and guidelines and insist that our muni bond manager abide strictly by them. The objectives will typically address the relative priority among capital preservation, liquidity, and income. The guidelines will also specify a target average duration for the bond portfolio (either an absolute target or, more commonly, a target set in relation to the municipal bond index we wish to have our money managed against); maximum and minimum durations for individual securities in the portfolios; minimum average credit quality for the overall portfolio; minimum credit quality for individual issues in the portfolio; maximum exposure to individual issuers (allowable exposures will differ depending on the perceived creditworthiness of the issuer types); use of leverage in the portfolio; employment of derivative securities; the amount of cash permitted to be held; and how the performance of the portfolio will be monitored and evaluated.⁷

In other words, in looking for competent municipal bond management firms, what we are really looking for is sophistication in the sector, intense tax awareness, sufficient volume to keep trading costs down, willingness to work as our agent,⁸ and strong internal control and management systems that will give us confidence that the manager can actually comply with our guidelines. Simply looking at past investment performance is less of a priority.

One final issue associated with municipal bond investing has to do with whether we should insist that all bonds in our portfolios be tax-exempt in the state where we pay income taxes. The trade-off here is higher after-tax income versus the increased risk that arises from having all our bonds concentrated in one state. Tax rates in some states are so high that most investors in those states will find it prudent to accept the concentration risk (California, Massachusetts, and New York, for example). Even in these states, however, it will sometimes pay to buy out-of-state bonds, and hence that flexibility should be given to our municipal bond manager.

In most other states, however, it will generally pay us to accept slightly reduced after-tax income in order to avoid highly concentrated bond portfolios. Assume, for example, that our muni bond portfolio is yielding, on average, 4 percent. Assume that the state income tax is 6 percent. If all our bonds were exempt from tax in that state, our net after-tax yield would be 4 percent. If none of our bonds were exempt from tax in that state (but were only exempt from federal tax) our after-tax yield would be 3.76 percent. Given that we can buy many in-state bonds that are fully tax exempt and still build a nationally diversified bond portfolio, our actual after-tax yield is likely to be much closer to the 4 percent that is maximally possible. And given the damage that can happen to our portfolio as the result of a series of downgrades (or, horrors, defaults) resulting from negative regional economic factors, we will generally be better off with a nationally diversified portfolio that has, perhaps, a state-of-residence focus.

Actively Managing Corporate Bonds

Most everything we have said thus far about managing municipal bond portfolios can also be said about managing corporate bond portfolios. The main difference is that the corporate bond sector is more efficient, hence fees should be lower. Aside from that, however, most of us will be better off either indexing in this sector or insisting that our corporate bond manager manage our account to our exact specified guidelines.

Indexing can be accomplished via, for example, the Vanguard Total Bond Market index fund. For bond portfolios over $250,000, Vanguard charges only 17 basis points (17/100 of 1%) per year. Larger portfolios can use the Vanguard Institutional version of the fund, which charges only 10 basis points, or can have their bond portfolios custom indexed by a large financial institution. There are also exchange-traded funds that offer indexed corporate bond management.

Bond accounts managed according to our own guidelines should be handled by bond managers who possess the systems and controls required to ensure that those guidelines are adhered to, and who manage sufficient bond assets to ensure reasonable trading costs. As emphasized above, we will want to work with a bond manager who is buying and selling bonds as our agent using other dealers, not with a brokerage firm selling bonds to us out of their own inventory.

High-Yield Bonds

I have put the discussion of high-yield bonds in the Fixed Income chapter because, legally speaking, high-yield bonds are in fact bonds—they pay a fixed coupon. But in virtually every other way, high-yield bonds are far more analogous to equity securities.

For example, high-yield bonds experience price volatility that is more akin to that of stocks than to that of bonds. In addition, the use of the proceeds raised by issuers of high-yield bonds is typically for longer-term corporate activities that would normally be funded by issuing equities, except that the company is not strong enough to be of interest to the equity market. Finally, astute investors treat high-yield bonds more like stocks in terms of how they spend, or don't spend, the return.

Most bond investors spend most of the return their bonds generate—the coupon payments—but most stock investors spend, if anything, only dividends paid on their stocks and often not even that. Because virtually all the return on high-yield bonds comes from their unusually high yields, investors who spend the entire yield will achieve a zero return (a negative real return) on their high-yield holdings. Hence, smart investors will tend to spend only a small portion of the yield on high yields, or spend none at all.

The term “high yield” is, of course, a euphemism. The traditional term for bonds issued by non-creditworthy companies is “junk.” The term was not changed in an effort to be Politically Correct—a disease happily almost completely absent from the financial services world—but for sales reasons. Investors who wouldn't touch a “junk” bond will snap up a bond that is described as having a “high yield.” It is, however, a useful corrective to keep in mind that, although bonds in this sector do indeed have high yields, they are in fact junk bonds.⁹

Bond ratings were created by credit rating agencies to assist investors in evaluating the credit quality of the issuers of bonds. The highest credit rating, AAA, is enjoyed only by the most creditworthy firms. As a result of their high standing, these firms have to pay interest on their bonds that is only slightly higher than the interest paid on U.S. Treasury securities with similar maturities. This difference between Treasury yields and yields on other bonds is referred to as the yield spread. Junk bonds—those bonds rated below BBB—are considered speculative grade by the ratings agencies and must pay much higher rates of interest in order to have any chance of selling their bonds. Hence, their spreads are much wider.¹⁰ (Bonds rated D are already in default.)

Junk bonds entered center stage in the capital markets with Michael Milken and Drexel Burnham Lambert in the 1980s. That episode ended in scandal and in the collapse of many of the lower-rated companies Milken had championed. Nonetheless, the notion that weaker firms should have access to capital was an attractive one, and many of the innovations launched by Milken survived his own troubles. Today, the junk bond market is thriving, and many firms that simply would not have survived in the capital-starved pre-Milken world have grown into pillars of the corporate community.

Junk bond managers range all over the lot, from managers who dip only slightly below investment grade (their portfolios will have average ratings of BB or BB–) to managers who deal in the true heart of junk bond land—the C credits—to managers (many of them organized as hedge funds) who deal in seriously distressed securities, many of which are already mired in bankruptcy proceedings.

Because the junk bond sector is highly cyclical, there are only two intelligent ways to play the junk bond game for most family investors. The first is to create a permanent allocation to junk (say, 10 percent) and to rebalance religiously back to that allocation whenever it is exceeded or whenever the actual allocation falls below the target. This disciplined rebalancing will introduce a countercyclical effect into the junk bond portfolio, causing us to sell junk when the bonds are outperforming and to buy junk when the bonds are underperforming. Over time, this will provide a nicely enhanced return to our portfolios and will inject considerable diversification.

A more sophisticated approach is to buy junk on an opportunistic basis, that is, whenever spreads significantly exceed their long-term norms, and to sell junk when spreads return to their long-term norms. This approach will provide higher returns, but it is difficult, both technically and emotionally, to implement.