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Thinking differently about bond allocation decisions

11/21/13

Interest rates have never been lower, so at some point we have to expect them to go higher. As an investor building wealth for the long term, should you be thinking differently about how you make bond allocation decisions?

Bond fund allocation has long been a fairly straightforward part of the overall portfolio allocation decision process. Bonds were traditionally the “safer” part of your portfolio that remained steady and predictable when riskier asset classes are in turmoil. In the past, the most basic allocation decision you can make is how much to allocate to equities and other risky assets, and how much to assign to bonds.

There is no doubt that bonds trade in a more volatile pattern than in the past. That by itself does not change the role they normally play in portfolio allocation. A bond portfolio still consists of securities that pay a contractually fixed stream of interest and principal payments over a defined period of time. The primary risks remain the same. For a long term investor that primary risk is the potential for bonds in a fund’s holdings to default, leaving the investor with the prospect of receiving less than 100 percent of the contractually promised payments. The other primary bond portfolio risk is interest rate direction. This is normally not seen as a long-term risk, because interest rates tend to rise and fall with economic cycles. But many experts are now making a case that the next 10 years or even longer could be a period where interest rate risk is as relevant to long-term bond portfolio allocations as credit risk.

Bond yields are currently still at unprecedented lows. The yield on the 10-year Treasury note reached a level in August of 2012 it had not seen at any time since the end of WWII. While stocks generally stayed firm and then rallied as the summer went on, bond yields have hovered close to those historical lows.

Having said this, bonds are still the steady hand of a diversified portfolio. With interest rate risk a concern, it may make sense to shorten the average duration of the bond portfolio. “Duration” is a technical for the bond’s term—what it means is that your bond portfolio allocation should be weighted towards issues that pay more interest in a shorter period of time. The shorter the duration, the less sensitive the bond price will be to changes in interest rates (a big advantage if interest rates are rising). At the same time you may also consider weighting more of the bond allocation away from ultra-safe governments to high grade corporates. Credit quality risk is fairly low these days for high grade corporates, as they tend to have lots of cash and relatively low levels of debt to equity. That may provide some additional opportunity for increasing the potential returns from your bond portfolio.

As always, it makes sense to seek expert financial advice before making any changes to your portfolio.

— Chip Gordy, MBA, CRPC is a Financial Advisor with Coastal Wealth Management, LLC, 10441 Racetrack Rd, Unit 1, Berlin, Md., 21811 and specializes in Wealth and Retirement Planning. He can be reached at 410-208-4545 or chip@coastalwealtmgmt.com. Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Advisory services offered through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Coastal Wealth Management LLC & Cambridge are not affiliated.

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