Why Not Manage A Bond Portfolio For Income?

Role of Bond Portfolio
Most investors own bonds to provide income and to dampen the volatility of the overall portfolio. We manage our bond portfolios for total after-tax return in order to accomplish both of these objectives. Some investors view their fixed-income portfolios solely as a source of income. The income approach to the portfolio often leads the investor to underestimate the additional risks that they take, and is a less desirable approach to managing bond portfolios. Income is only half of the equation. The total return of any bond is the income plus the price change. Income without consideration of the change in asset value is of particular concern when investing in low quality bonds. These bonds have a high correlation to equities. This means that an investor with a large position in these types of bonds has done little to dampen the volatility of the overall portfolio, because when stocks go down, high yield bonds go down as well. This is contradictory to the basic principle of diversification. The investor has added to his equity risk, rather than reduced his risk.

Increased Risks From Income Approach

Credit Risk
Lower rated riskier bonds generally have higher yields. Investors that are chasing yield often end up with these securities. It is similar to a bank robber who gets caught. When asked why he robbed banks his answer was, “because that is where the money is!” Junk bonds are like a magnet for investors who are only looking at the yield the bond might pay. There is no riskier strategy for most individual investors than to take too much credit risk. Why risk 100% of your money to get an additional 1% return? We advise investors to avoid credit risk, and put that money into a higher return asset class, such as equities, where the potential returns are much higher.

Inflation Risk
Some investors may say “when rates are at 5% I am going to put my money into long bonds and forget about them”. This leads to increased market risk and the risk that inflation will erode their future earnings stream. Economic conditions need to be monitored to make sure that inflation doesn’t become a problem again. A better strategy is to have some shorter maturities so that if rates rise maturities can be reinvested in higher yielding securities, and some longer maturities to help protect the income stream in case rates fall.

Reinvestment Risk
In the search for additional yield it is not uncommon for investors to ignore call features on the securities they purchase. This leads to reinvestment risk. A long bond with a short call is very undesirable. If rates rise you are locked into a long maturity at a low yield. If rates fall you have your bonds called away. Either way the investor loses. Who wants to play that game?

Tax Risk
Often muni bond investors will buy bonds that are subject to the Alternative Minimum Tax. These bonds pay a little higher rate than a regular muni, but the consequences of owning the AMT bond are disastrous if the taxpayer’s status changes and he/she finds themselves subject to the AMT. In that case, the interest is then taxed as if it were a taxable bond. We have found that most investors are better off not purchasing AMT bonds.

Components of Total Return That Are Ignored

Yield Curve Shifts
Prices in the bond market change daily. We call these changes in market value due to changes in yield for each maturity, yield curve shifts. When the bond market is volatile, these shifts are a significant part of total return.

Changes in the Composition of the Yield Curve
When money is tight, the yield curve normally flattens. When the Fed eases, the curve normally steepens. These changes are important aspects of the portfolio’s return. Sometimes the best strategy is a barbell strategy. This works well in a flattening curve environment.

Credit Quality Spreads
After tightening during the last 3 years, quality spreads were recently blown out to more traditional levels. Holders of virtually all high yield bonds saw significant declines in the value of their holdings. While these bonds declined in value, high grade bonds rose in value. We experienced a flight to quality rally in the U.S. Treasury market.

Conclusion
Bond performance consists of two parts, income and price change. It is a mistake to manage a portfolio only for income, because income is only half of the story. This approach often leads to higher levels of portfolio risk, and poorer relative performance than a total return approach. This is not the style of most professional bond managers. So, who would take this type of approach? We see this style primarily when an individual is managing his/her own portfolio and is working with a broker who is selling them securities. These individuals are captivated by the higher yields, and don’t know that there is more to managing a bond portfolio than clipping a big coupon.