Apr 10, 2017

How to Improve the Risk Return of your Bond Portfolio

A well balanced investment portfolio typically has a bond component which will help to smooth out the volatility of the portfolio and gives investors some safe buffer to take advantage of any market correction or crash when it occurs, without needing the investor to top up the investment portfolio with cash.

As the global economies move towards the more mature end of the economic cycle, it is often prudent to lock in the profits made during the better times and increase the allocation towards bonds.  However, in the current rising interest rate environment, the performance of bonds will be affected.

So how can investors increase the returns of their bond in a rising interest rate environment and maintain the principle objective of a bond allocation as a form of safe haven?

Decrease the duration of bond
A bond is like a longer term fixed deposit, the longer the duration, the higher interest it will draw. However, as interest rate rises, the fixed deposit you invested in today will be worth less as investors can now go to the bank to get a new fixed deposit with a higher interest rate. In order to capture the rising interest, investors should invest in a bond that has short duration, which matures quickly so that investor can roll over the bonds which has matured and buy into the higher interest rate bond. This strategy will allow investors to improve their returns over time and at the same time, gives the element of protection.

Invest in TIPS or Higher Risk Bonds
An rising interest environment is normally driven by 2 factors, a growing economy and a rising inflation. In order to take advantage of this situation, investors can improve the returns of their portfolio by allocation a proportion into Treasury Inflation Protected Securities (TIPS) or High Yield Bonds.

Treasury inflation protected securities (TIPS) refer to a treasury security that is indexed to inflation in order to protect investors from the negative effects of inflation. Here is the description of TIPS from Investopedia: TIPS are considered an extremely low-risk investment since they are backed by the U.S. government and because the par value rises with inflation, as measured by the Consumer Price Index, while the interest rate remains fixed.

High Yield Bonds are considered to be the riskier cousins to investment grade bonds as they command a higher interest due to the riskier financials of the governments and companies that issue these bonds. In terms of risk and return, high yield bonds have similar returns to equities depending on the environment. For example, during the 2003-2007 cycle, whereby the interest rate is being raised rapidly during 2005-2006, the returns of high yield bonds was impacted but at the same time, become a natural dampener of risk which result in a much smaller investment return loss. The rising interest rates act like a "cooling measure" towards High Yield Bond while the returns of equities continue to rise and crash with higher intensity during the same period. Meanwhile, as a result of consistently low interest rate environment, high yield bonds essentially behave like a stock. However, as the intensity of interest rates may increase in the near future, this may put a dampener on the return of the High Yield Bond but at the same time, improving its recession protection should the market cycle turns in the near future. However, the potential downside of the high yield bond will defeat purpose of the safety buffer of bond in the first place, which means a slightly lower risk/return instrument might be more suitable.

Best of Yield and Capital Preservation
A compromise between getting better return and some level of capital preservation might be found in the solution of a short duration high yield bond. Back to the idea of duration, the longer investor lend out money to institutions, the higher chance that they may not get the money back due to higher probability of companies going bust in the long term.

However, if a shorter duration bond is used, the risk of the company unable to pay back decreased considerably. A short duration high yield bond provides a certain element of protection against rising interest rates, relative lower risk of default in the growth to stagnant phase of the economic cycle and yet return higher return as compared to a no risk treasury bill. Having said that, the, investors should be careful even using short duration high yield bond as it can have the potential downside of 5-10% during bad times, so it should be used at certain periods of the economic cycle to enhance returns.
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