Bonds are generally issued at par, redeemed at par, and as you go along 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, but the volatility of long-term bonds may 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 top 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 would want them at all. Of course, not all investors have similar needs. Many institutions tend to be more enthusiastic about matching future liabilities with assets than maximizing total return. As an example, life insurance companies can estimate their future liabilities with some precision. Having bonds that mature on schedule allows them to complement assets with expected requirements. Statutory regulations require them to keep 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 whilst the spread.
That's not the situation we face as individual investors, though. You want to maximize our return per unit of risk, and bonds don't easily fit into very well. When we plot the risk/reward points for a number of well-known long-term bond indexes from 1978 to 1997, we note that each of them fall far below the conventional risk-reward line. Not really a pretty sight, could it be?
On 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 in our asset allocation plans: They can reduce risk to tolerable levels in a portfolio, and they are able to give a repository of value to fund future expected cash-flow needs. Of course, we don't expect the bond portion of the portfolio to become a dead drag on its overall performance. It makes sense to take prudent steps to improve returns in every portion of the portfolio. Let's take a peek at a few of the common methods employed by fixed-income investors to see if any might advance that goal.
Junk Bonds
Investors take on more risk if they spend money on lower-quality bonds. While they are able to 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
We all know that the capital value of a relationship whipsaws as interest rates in the economy change. So, if we'd an accurate interest-rate forecast, we could develop a trading strategy to reap capital gains. Buying long-term bonds before interest-rate declines will produce gratifying profits. Pretty simple, huh? The difficulty is, accurate interest-rate forecasts are elusive. Seventy percent of professional economists routinely fail to predict the correct direction of rate movements, not to mention their magnitude.
Individual bond selection is suffering from exactly the same problems as equity selection. The marketplace is efficient, and finding enough mispriced bonds to help 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 relationship between maturity and return is expressed whilst the yield curve. When longer-maturity bonds have higher yields, that is the majority of the time, the yield curve is considered positive. As you can see in the graph below, yield typically rises very gradually, while risk takes off sharply beyond a one-year maturity. On a risk/reward basis, bonds with maturities greater than five years are usually 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, a simple 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 market at a lower rate. This captures both yield on the bond although it is held, and a capital gain on the difference in price. premium bonds to invest Throughout the few instances when the yield curve is not positive, simply hold short-term bonds. Nothing is lost as the rates are higher here anyway. While the process involves trading, it does not require any kind of forecast to be effective. The yield curve is simply examined daily to find out optimum buying and selling points. To be effective on an after-trading-costs basis, only probably the most liquid bonds (U.S. Treasury and high-quality corporate bonds) can be used. Over time, a relationship portfolio with an average duration of only couple of years could be enhanced by 1.25% applying this technique.
Foreign Bonds
Theoretically, at least, the greatest reason for yield differences between foreign and domestic bonds is currency risk. If you had been to totally hedge currency risk, you should theoretically be straight back at the T-bill rate. In real life, opportunities exist to buy short-term foreign-government bonds, hedge away the currency risk, and still have a greater yield. Benefiting from these "targets of opportunity" can further enhance a short-term bond portfolio, perhaps by a share point or two. Of course, if you will find no such opportunities during a particular period, just buy domestic bonds.
