There's been a lot of commentary about how the fundamentals of the bond market are deteriorating. Warren Buffett recently weighed in on the subject in his annual letter to Berkshire Hathaway shareholders, saying, "Right now, bonds should come with a warning label."
I find it hard to argue with the Oracle on most issues; this one is no exception. Interest rates will be going up -- it's just a matter of time. Sovereign debt problems in the euro zone and other developed countries are still casting a pall. Perhaps most importantly, government bonds currently pay less income than stocks for the first time in 50 years. As of close today, May 23, 2012, ten year government bond yields are 1.735 per cent for the U.S., 1.878 per cent for Canada and 1.384 per cent for German bunds. Average dividend yield for those markets (as measured by the yield on comparable ETFs) is 2.0 per cent, 2.8 per cent and 3.4 per cent respectively. Add it all up and it seems that a perfect storm is brewing for bonds.
So what should you do about it?
Ah, that is the question. While many commentators have been quick to point out the problems with bonds, they haven't been all that forthcoming with the solutions.
Let's be clear here: liquidating your bond portfolio and stuffing the cash under the mattress is not the answer. The fact of the matter is, the security bonds offer and their regular income makes them an essential component for anyone who relies on their portfolios for income. It's been that way for the past 50 years, and it's likely to be that way for the next 50 to come.
However, that doesn't mean investors should just ignore the coming storm. I've been speaking to many HNW clients and associates, as well as with Tiger 21 members about what they're doing with their bond portfolios. No one has found a "silver bullet" to this problem -- because there isn't one. Instead, most HNW investors have been pursuing a number of strategies to prepare their bond portfolios for the "new normal."
Trimming overall exposure and shortening duration/terms Most HNW individuals have decided that now is not the time to go "all in" on bonds. Just the opposite. There is still a core bond exposure, but the percentage of the portfolio allocated to bonds has come down considerably over the past couple of quarters. Generally speaking, investors are getting by with less government bond exposure and becoming more intrigued with high-yield bonds (more on that below).
Equities as the new bonds At the same time as they are trimming their bond exposure, many HNW individuals are putting money into blue-chip, dividend paying equities.
This chart makes it clear why. At the end of last year, dividend yield for the TSX surpassed the government of Canada long bond yield for the first time in 50 years (the difference would have been even more pronounced in after-tax terms). Altogether, a pretty strong argument for swapping at least some of your bonds for high-quality dividend-paying equities.
"Back to basics" with core bond positions HNW individuals currently have little interest in betting big on duration or on a single bond issue. Instead, most investors are spreading risk around the yield curve. Call it the "sleep at night" strategy.
I think this is a very smart move. Bond ladders are cost-efficient and you don't need a PhD in finance to put one together. A bond ETF provides much the same diversification in an extremely cheap package. Look for ones that have "tax alpha" structures to enhance returns further.
Explore global high-yield There's been a lot of interest (if you'll pardon the pun) in high-yield corporate bonds over the past few years. In part, that's a reaction against the exceptionally low yields on government bonds. But it's also because of lower interest-rate sensitivity: high-yield corporate bonds are more affected by company-specific factors ("credit risk"). Interest rates don't have as much impact on their prices as they do with "govvies."
I don't think high-yield corporate bonds are appropriate for all investors, not even all HNW investors. And they should not be a "core" position: shoot for a maximum 10-35 per cent of your overall bond portfolio (depending on your risk profile of course).
Bond diversification Back in the day, bond portfolios used to be very monotone, with developed-market government bonds comprising the vast bulk of an investor's bond portfolio. But that's changing: emerging market bonds have really come into their own over the past few years, to some degree as a reaction to potential currency crises in the developed world. I think this is a welcome change. There's no reason why bond investors shouldn't consider geographic diversification as much as equity investors do.
Inverse investing or shorting Knowing bond prices are likely to go down creates an interesting opportunity for more aggressive investors. Some HNW individuals have very recently taken short positions on U.S. Treasuries and other bonds; inverse bond ETFs offer the same kind of exposure. Some HNW individuals I know are also placing money with expert managers (typically in the hedge fund space) who know how to do this kind of investing. I advise caution here: such investments can be viewed as risk management or speculation depending on how you use them. But make no mistake: there are people who will make a lot of money on this trade over the next 5-10 years, however investors will need to be nimble within a tactical asset allocation framework.
Thane Stenner is founder of Stenner Investment Partners within Richardson GMP Ltd., as well as portfolio manager and director, wealth management. Thane is also Managing Director for TIGER 21 Canada. He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)'. ( www.stennerinvestmentpartners.com) (Thane.Stenner@RichardsonGMP.com). The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.