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Income-seekers: these 'myths' could come back to haunt you

It’s late in a decades-long bond rally, and it’s safe to say that the current, ultra-low interest rate environment is messing with our heads.

Who, at the outset of 2014, would have guessed that bonds would put on such a rally? And fewer still predicted that long-term government bonds – deeply unloved by most investors for their extreme sensitivity to interest rate changes – would be one of the best-performing categories, gaining more than 20% in the US in 2013 and 12% in Australia. With interest rates so low, you need to whip out an electron microscope to see the yield on your core bond fund, never mind cash. Low interest rates have left many income-oriented investors scrambling for yield and given rise to a lot of questions. If interest rates rise, where should bond investors go for insulation? Will individual bonds, dividend paying stocks or cash be safer than the core bond funds that so many investors have been counselled to hold?

The answers aren't clear-cut, which in turn leaves plenty of room for confusion. Here are a few of the myths that are swirling around income-producing securities. Granted, not all are out-and-out falsehoods; some of them may hold up in certain situations. But at a minimum, investors shouldn't accept them without first thinking through their own situations, especially their time horizons.

Myth 1: if rates are going to rise, you're always better off buying individual bonds than bond funds

This one comes up a lot, and it's not as though there isn't some truth to it. If you buy an individual bond at the time of issuance and hold it until maturity, you will get your money back in the end, as well as your interest payments along the way, assuming you bought the bond from a creditworthy issuer.

By contrast, you won't always get the same amount back from your bond fund that you put in. For example, say you put money into a long-term bond fund and interest rates shot up by two percentage points between the time of your purchase and the time you sell. It's very likely the bonds in the portfolio would have declined in value over your holding period, even if the yield on your fund perked up. (Of course, the opposite can also happen; rates can go down, as they did in 2014, and the bond fund holder may see his or her principal value grow, even as the fund's yield has declined.)

For some investors, that may seem like an out-and-out indictment of bond funds, especially given the likely rising long-term direction of interest rates. But while buying and holding individual bonds may help you circumvent one type of risk that the bond fund holder would confront head-on, you could still face an opportunity cost, which is also a risk.

If rates rise and you're determined to not take a loss on your bond, you're stuck with it until maturity. Meanwhile, as the various bonds in a fund's portfolio mature (and even if they don't), the bond fund can take advantage of new, higher-yielding bonds as they come to market. That helps offset any principal losses the fund incurs as rates go up.

Individual bond buyers can do something similar by building bond ladders, purchasing bonds of varying maturities to help ensure they can take advantage of varying interest rate environments. But it may take a lot of money to both ladder a bond portfolio and obtain adequate diversification across varying bond types. And by the time the investor does, the portfolio may look an awful lot like – you guessed it – a bond fund. Individual bond buyers may also face sizable trading costs. Of course, an individual may still opt to buy individual bonds rather than a bond fund but it's not true to say that doing so is automatically less risky than buying a fund. It's a trade-off.

Myth 2: high dividend-paying stocks are safer than bonds

In a related vein, some investors have dumped bonds altogether, supplanting them with high dividend-paying stocks. As well as the dividend stream, they may also gain some capital appreciation if the stock increases in value over the holding period and the company may also increase its dividend.

But as with buying individual bonds, there's a trade-off. Of course, stocks, even high-quality dividend payers, have much higher volatility than bonds, making them poor choices for investors who may need to pull their money out in less than 10 years. Moreover, stocks won't be impervious to interest rate increases and because investors increasingly have been using dividend payers as bond substitutes, they may be vulnerable to selling if rates head up and bonds become a more compelling alternative. Finally, it's worth noting that companies can cut their dividends in times of distress, as was painfully apparent to many dividend-dependent investors during the financial crisis.

Myth 3: cash is safer than bonds

This one, of course, technically is true. If you have money you can't afford to lose because you're going to use it next year to pay a big bill, it's best not to nudge out on the risk spectrum and into bonds. That holds true regardless of the prospective direction of interest rates.

But if your time horizon is longer, sinking too much into cash means you're virtually guaranteed to lose money once inflation is factored in. Investors might say that they'll steer their bond money to cash for only so long as it takes interest rates to go back to more meaningful levels and the threat of an interest rate shock has subsided. But how will they know when that is? As with any market inflection point, there won't be clanging bells letting you know it's OK to get back into bonds. Instead, a better strategy is to match your time horizon to the duration of your bond holdings: very short-term assets in cash, intermediate-term assets (with a time horizon of, say, three to 10 years) in core bond types and long-term assets in a diversified equity portfolio.

 

Christine Benz is Director of Personal Finance at Morningstar. This article was first published by Morningstar and is reproduced with permission. The information contained in this article is for general education purposes and does not consider any investor’s personal circumstances.


 

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