By John Wasik
CHICAGO Feb 19 When U.S. Federal Reserve
governors start talking about "overheating episodes in credit
markets," as did Jeremy Stein in a Feb. 7 speech in St. Louis,
it is time to prick up your ears.
Stein warned that in an attempt to "reach for yield,"
investors have been taking on ever-greater risks in vehicles
like high-yield corporate "junk" bonds, insurance products and
real estate investment trusts. And that means that even though
most of the drama in recent weeks has been focused on a bullish
stock market - the S&P 500 Index is up nearly 7 percent
year-to-date through Feb. 15 - you need to pay even closer
attention to bonds.
Of course, yield-hungry bond investors are taking risks
because they have been frustrated since 2008, when the Federal
Reserve slashed interest rates to practically nothing. The Fed
is expected to keep rates low through 2014.
But an economy that is gaining steam can lead to inflation,
which is typically the enemy of bond prices. You may need to
rework your portfolio now to spread around risk.
The main argument for bond caution, at least as it concerns
U.S. Treasury bonds, is what has become known as "financial
repression." Many critics of the Federal Reserve believe that by
keeping rates so low for so long to re-float banks, bond yields
are not reflecting what is going on in the larger economy in
terms of growing inflation. Yields should be much higher, and
perhaps will eventually reflect actual conditions and then
depress bond prices.
One prominent voice urging caution is Burton Malkiel's. An
emeritus professor at Princeton University, he is now on the
investment advisory board of Rebalance IRA, a company that sets
up low-cost index fund portfolios for clients. He says simply
that he is "not a fan of bonds now."
Because of the growing risk in the U.S. bond market, Malkiel
surmises that emerging market debt may be less risky than
American bonds. He still believes in diversification, however.
"There's a necessity to fine-tune your income strategy," he
said. "Diversify more, even more so than in the past. Investors
who can't stomach volatility should look at their bond
What does reworking your bond portfolio mean in practical
terms? You will need to see where most of your income portion is
concentrated and make some changes. First, identify those
vehicles most vulnerable to changes in interest rates. Bond
mutual funds or exchange-traded funds that hold securities with
mid- to long maturities - five years or more - need your
attention first. Then look at some alternatives:
- iShares JP Morgan US Dollar Emerging Markets Bond ETF
. The fund tracks an index of emerging-markets bonds. It
is currently yielding 4.3 percent.
- iShares Barclays TIPS Bond ETF. Unlike
conventional treasury bonds, Treasury inflation-protected U.S.
Bonds or TIPS pay a premium yield based on inflation. While the
cost of living has been low in recent years - and TIPS returns
have been paltry - the fund is yielding 2 percent now.
- SPDR Barclays High Yield Bond ETF. Investing in
low-rated corporate "junk" bonds, this higher-risk fund is
yielding almost 7 percent. This fund tracks an index of junk
- Vanguard High Dividend Yield Index ETF. If you can
afford to take more stock-market risk, this index fund invests
in high-dividend stocks and offers a 3 percent yield.
- Vanguard Total Bond Market ETF. The index fund
invests in a broad swath of the U.S. bond market. Although the
yield is under 3 percent, it holds more than 3,000 bonds.
At the very least, if you need income, hold fast to the
virtue of diversification. Spread out your holdings by issuer,
type, region and country. Always look at a bond or portfolio's
duration, which is how much you can lose if interest rates climb
1 percentage point.
Single bonds, for example, offer you very little
diversification and large exposure to credit risk, although
little interest-rate risk if you hold them to maturity and they
carry the highest ratings.
Those perturbed by low yields should avoid any income
products that promise outlandish yields. Unlisted REITs,
structured notes and some variable insurance products that are
illiquid and highly risky have been promising investors
unrealistic returns over the past several years. Avoid them.
A truly diversified income portfolio holds municipals, high-
and low-yield corporates, U.S. Treasury, U.S. agency, and
non-U.S. bonds. If you cannot achieve this kind of
diversification on your own, seek the services of a financial
planner, registered investment adviser or chartered financial
analyst who can set up or remake your portfolio to buffer it