Bonds have had a very good 2014 as the 10 year treasury yield decreased from 3.0 percent on January 1 to a current yield of around 2.35 percent.
Many investors and money managers are now wondering what to do with their bond allocations as 2015 approaches. This is a difficult question with the specter of a rising Fed Funds rate and higher valuations across all asset classes.
Below are thoughts on some major bond classes, keeping in mind balance risk reduction and maintaining some positive returns over the next 12 months.
This has been one of the best performing bond classes this year, with the Ishares National Municipal index fund (NYSE: MUB) up around 8 percent through October. Longer dated municipals are up more than 13 percent as measured by the Powershares National Muni ETF (NYSE: PZA). This performance was aided by two components: the lowering of overall interest rates and the compression of favorable yield spreads between municipals and treasuries present at the beginning of the year.
Because the upside in both those areas could largely be pasr, trimming some exposure to municipal bonds makes sense. Concentrating on allocation in maturities in the 10-15 year range is recommended, as any longer a lot of the additional "juice" could be largely exhausted and much shorter typically provides little yield. Assuming an investor still has a decent amount of stock holdings in their portfolio and has a reasonably high tax rate some exposure still makes sense.
Investment Grade Bonds
Investment grade bonds also had a very good 2014 with the iShares Investment Grade fund (NYSE: LQD) up about 7.3 percent on the year. Like municipal bonds, this sector benefited largely from decreasing interest rates through the year. Also, like municipal bonds, trimming exposure here makes sense as there is very little further spread-tightening prospects and interest rates are not foreseen decrease a great deal from here (if anything a slight rise in rates could occur).
Allocation makes the most sense in the 7-12 maturity range here, as shorter term bonds yield no more than 1-2 percent with some credit risk.
High Yield Bonds
"Junk bonds" were one of the worst performing bond classes this year, as the decrease in rates were somewhat offset by a widening of credit spreads. This is the one area of the bond market that on a relative basis has a little better valuation this year versus last. A marginal add of exposure here might be a good idea as long as you can take more equity-like risk. Yields of 5.5 percent or so is attainable with bond funds like the iShares High Yield fund (NYSE: HYG) or the SPDR short term high yield fund (NYSE: SJNK).
Alternative Ideas For 2015 Allocations
There are a few areas of the bond market that look good for an allocation or an add to an existing position over the next 12 months.
Chinese investment grade bonds: These bonds offer a 3.3 percent yield (roughly the same as American Investment grade bonds), but with less interest rate risk. Now that rates are substantially lower, these less interest rate sensitive bonds offer some appeal, although when buying you are in effect investing in the Chinese currency as well.
‘Barbell Strategy': While most alternative or unconstrained bond funds carry a higher risk, Doubleline's Total Return fund (DBLTX) is a standout. They employ a fairly simple strategy of owning low/no duration mortgage bonds with good yields and longer treasuries balancing the former position out in terms of risk. At the same time, the total yield on the strategy is between 4 and 5 percent. In 2013 as interest rates increased substantially the fund did not lose money.
‘Flattening of the yield curve': It is possible that as the Fed increases short term rates sometime in 2015, while the longer term bond yields remain little changed or only nudge up slightly. This will cause a ‘flattening' of the yield curve. An easy way to play this move is to buy the iPath US Treasury Flattener ETN (NYSE: FLAT). If the spread between short term yields (likely moving up) and longer term yields decreases, this trade would make money.
Eric Mancini is the Director of Investment Research at Traphagen Financial Group, an independent investment advisory firm located in Northern New Jersey.
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