Bonds are usually issued at par, redeemed at par, and on 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, nevertheless 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 property class are so dismal that you might wonder why any investor will need them at all. Of course, not all investors have similar needs. Many institutions are far more thinking about matching future liabilities with assets than maximizing total return. For instance, life insurance companies can estimate their future liabilities with some precision. Having bonds that mature on schedule allows them to fit assets with expected requirements. Statutory regulations require them to put on 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 since the spread.
That's not the specific situation we face as individual investors, though. We want to maximize our return per unit of risk, and bonds don't fit in very well. If 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 standard 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 within our asset allocation plans: They are able to reduce risk to tolerable levels in a portfolio, and they could provide a repository of value to fund future expected cash-flow needs. Of course, 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 in every percentage of the portfolio. Let's take a look at a number of the common methods employed by fixed-income investors to see if any might advance that goal. invest in bonds
Junk Bonds
Investors take on more risk if they spend money on 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 get paid 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 connection whipsaws as interest rates in the economy change. So, if we had a precise interest-rate forecast, we're able to develop a trading strategy to reap capital gains. Buying long-term bonds before interest-rate declines will produce gratifying profits. Pretty simple, huh? The trouble is, accurate interest-rate forecasts are elusive. Seventy percent of professional economists routinely neglect to predict the correct direction of rate movements, not to mention their magnitude.
Individual bond selection is suffering from the same problems as equity selection. The market 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 partnership between maturity and return is expressed since the yield curve. When longer-maturity bonds have higher yields, that will be most 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 take off sharply beyond a one-year maturity. On a risk/reward basis, bonds with maturities greater than five years are generally 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 chance line is significantly steeper compared to 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 sell at a lower rate. This captures both the yield on the bond while it is held, and a capital gain on the difference in price. Throughout the few instances when the yield curve is not positive, simply hold short-term bonds. Nothing is lost because the rates are higher here anyway. While the task involves trading, it does not require any type of forecast to be effective. The yield curve is simply examined daily to ascertain optimum buying and selling points. To work on an after-trading-costs basis, only the absolute most liquid bonds (U.S. Treasury and high-quality corporate bonds) could be used. With time, a connection portfolio with an average duration of only two years might be enhanced by 1.25% employing this technique.
Foreign Bonds
The theory is that, at the least, the greatest reason behind yield differences between foreign and domestic bonds is currency risk. If you had been to totally hedge currency risk, you ought to theoretically be straight back at the T-bill rate. But in real life, opportunities exist to purchase short-term foreign-government bonds, hedge away the currency risk, and still have an increased yield. Using these "targets of opportunity" can further enhance a short-term bond portfolio, perhaps by a portion point or two. Of course, if you will find no such opportunities during a particular period, just buy domestic bonds.
