Ways To Survive Bond Bubble

OCEAN CITY – After two equity downturns in the past 10 years, many investors have sought refuge in U.S. Treasuries. A growing appetite for lower-risk bonds has driven prices up and yields down; in early November, three-year Treasuries yields were hovering around a meager 0.5%.

But a portfolio that relies too heavily on this kind of strategy now may face very real problems later. Although the Consumer Price Index has risen only 1.1% this year, the long-term average inflation rate was 3.0%, as of the end of October, according to Ibbotson Associates.

In other words, a portfolio applying too conservative a strategy could now actually be eroding net worth. Furthermore, today’s historically low interest rates are likely to rise eventually; in that case, new bond issues would typically become less expensive, driving prices down and raising the specter of a "bond bubble" in which those who are overinvested in fixed income could face real capital losses. But a more conservative strategy need not mean stagnation. Here are three ways to both improve yield potential and help preserve your portfolio from overexposure in an uncertain bond market.

The cash alternatives: "The Federal Reserve may end up waiting until early 2012 before raising short-term interest rates," says Jeffrey A. Rosenberg, a Credit Strategist at BofA Merrill Lynch Global Research, "but for Fixed Income investors that may just not matter if fears of future inflation lead to rising interest rates." That prospect now appears on the horizon, as despite the Fed’s buying program, longer term interest rates have increased.

Although some investors will be tempted to hold cash, which tends to maintain value in almost all market conditions, money market funds and other cash instruments have currently been providing negligible yields, recently around 0.1%. There may be other alternatives. One option that Rosenberg suggests considering is high-yield corporate bonds. These can offer significantly more yield potential than more conservative alternatives, and that extra yield can help offset potential capital losses in a rising interest rate environment. However, larger interest-rate increases could erode principal in excess of that extra yield.

Finding resilience in premium bonds: Another option is to consider bonds selling at a premium — that is, bonds priced higher than current market rates. A premium bond can be more resilient than most comparable bonds because of its higher coupon. "Premium bonds tend to be defensive in a rising-rate environment, because their price is less sensitive to a change in interest rates," says Anita Mushell, Director of Fixed Income Due Diligence for Bank of America Merrill Lynch.

Seeking lower risk, higher income: It may also pay to look beyond conventional corporate bonds to hybrid and trust-preferred securities, which are issued by banks. Preferred issues resemble bonds in that they deliver fixed interest payments, but they trade on exchanges like stocks. Typical issues recently yielded 6% or more, partly to compensate for the risk of holding the securities to maturity, which is usually 10 years or longer. That risk can be significant: Because they’re heavily concentrated in the financial sector, preferreds tend to be more susceptible to volatility in that area, and many investors suffered losses when they fled to these issues during the recent financial crisis.

The eye for yield will likely remain a factor as long as fixed income remains a more conservative strategy for investors. Speak with your financial advisor to find ways to moderate risk in both your bond holdings and your portfolio as a whole. This will help you develop strategies that can thrive in a variety of bond markets.

(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)