Robert Johnson has spent most of his career studying and teaching modern portfolio theory. So it may come as a surprise to some that Johnson, 57, has not a penny of his portfolio in bonds.
 
“The absolute best-case scenario for bond investors is that rates remain low in the near future, which means your best hope is the status quo with no upside,” says Johnson, president and CEO of the American College of Financial Services. “If you lock in bonds at these levels, you’re locking in a purchasing-power loss.”
 
Not long ago, the notion of a no-bond portfolio would have seemed crazy. But what’s really crazy, says Johnson and many of his peers, is clinging to the conventional wisdom. “What are bonds supposed to do?
 
They’re supposed to preserve wealth, provide periodic cash flow, and hopefully some price appreciation,” he says. At the moment, however, they aren’t offering much in the way of income, and there is a real possibility that investors could lose money.

Beyond Bonds: Finding Income of 4%-5%


Portfolio manager Anne Lester of JP Morgan is scouring the globe for interest-bearing investments. Here’s where she’s getting them.


Although the bond market is anything but simple, the math is. The bull market for bonds began in September 1981, when the yield on the 10-year Treasury peaked at 15.84%. Over the past three decades, yields across the board have steadily fallen, with the bellwether 10-year dipping as low as 1.63% in May 2013. Recently it has hovered around 2.3%. As yields have fallen, bond prices have gone up, and up, and up.

That worries Johnson, and it’s the reason that Warren Buffett declared, in 2012, that bonds should come with a warning label. When interest rates do finally swing the other direction, investors will most likely flock to newer, higher-yielding bonds, and the prices of today’s bonds will decline, perhaps precipitously.

Investors who own individual bonds and hold them to maturity are insulated, of course; barring a default, they’ll still get their principal and interest.

Bond mutual funds and exchange-traded funds are a different story. These funds, by and large, don’t aim to hold bonds to maturity, and even if they did, the strategy works only if investors stay put. If fund investors run for the exit, managers have no choice but to sell into a declining market.

That exit may be already starting. In the first five months of the year, investors put more than $75 billion into taxable and municipal-bond funds, according to Lipper. But in June, the trend turned, with investors withdrawing a net $17 billion. If that presages a bigger exit, bond funds could fall sharply.
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Bond funds tend to hold their value -- unless rates are rising. Is it time to dump your bond fund? Illustration: Gary Hovland for Barron's
 
 
“This might be blasphemy, but if you’re worried about rising rates, you’re almost better sitting on cash than going into a bond fund,” says Shari Burns, managing director of United Capital Financial Advisors in Seattle.

Further complicating matters are growing concerns about liquidity in the bond market. Broker-dealers are no longer willing to buy bonds unless they have a buyer already lined up. Meanwhile, the proliferation of ETFs has paired ultra-liquid vehicles with not-so-liquid assets. “If you have a bond fund or an ETF, you don’t have any maturity. That’s not a bond; that’s a stock,” says Ron Weiner, CEO of RDM Financial Group, a wealth-advisory firm with offices in Connecticut and Florida. “There is a real, real risk in bond funds.”

THAT RISK DOESN’T get talked about very often, and most investors approach retirement with a big stake in bond funds. “A lot of individual investors don’t understand that they could actually lose money in their bond funds,” says Raj Sharma, a managing director of Merrill Lynch Private Banking and Investment Group in Boston. Though he hasn’t abandoned bonds altogether, he does think investors could stand to lighten up on fixed income. “What you’re doing is rebalancing and moving away from an extremely overvalued asset class,” he explains. “You wouldn’t buy a stock with a price/earnings of 100, so why would you buy a bond that is overvalued?”

The answer in the near term may be to shift money from bonds into cash. A longer-term solution is more problematic. “It’s hard to figure out how to balance the need for yield against the risk of assets falling,” says Hersh Cohen, co-chief investment officer for Legg Mason’s ClearBridge Investments group.

Mathematically, a higher allocation to stocks makes sense, says Cohen, who is manager of the ClearBridge Dividend Strategy fund (ticker: SOPAX). “But most people don’t have the temperament to have all their money in stocks,” he says.

NO DOUBT, ONE OF THE BIG arguments for sticking with bonds is that they are still the best insurance policy against stock market declines. “People have a short-term memory of the role fixed-income plays,” says Jay Sommariva, a senior portfolio manager at Fort Pitt Capital Group in Pittsburgh. Case in point, he says, is 2008, when “once the dust settled, the bonds that didn’t have credit problems bounced back before stocks.”

Even so, investors could be in for a rude awakening. The bond market has, for the past three decades, been exceptionally generous to investors. “Because rates have been falling, every time an investor wanted to get more conservative, there was very little to give up [in return],” says David Lafferty, chief market strategist of Natixis Global Asset Management in Boston. “Bonds do still play a role, but investors need to reset their expectations.”
 

There was a time when bonds could do it all—provide stability, income, and capital appreciation.

Those days are over. Now, investors need to pick their focus. And that focus should be determined by an investor’s need, rather than a hackneyed asset-allocation plan that decrees 55-year-olds dump 55% of their assets into bonds.

But even if the conventional wisdom no longer holds true, the advice is very much the same as it ever was: Know thyself as an investor, and construct a plan that suits your timeline and temperament. That is how Johnson arrived at his no-bond portfolio. “There is a willingness and an ability to take on risk, and I have both,” says Johnson. “I’m gainfully employed and have no plans to retire any time soon. But there are people in the same exact situation who couldn’t sleep at night if the stock market fell 20%.”

MOST INVESTORS NEED some form of stability, but that can mean many different things. For some it’s psychological: When the stock market hits the skids, it’s what keeps them from making short-sighted decisions. For others, stability has practical implications: They need a certain amount of money at the ready, whether for an impending expense, or in the case of retirees, to cover living expenses.

If you fall into the first camp—you want to minimize the emotional stress of a stock market correction—a small allocation to an intermediate-term bond fund will still offer ballast against big stock market losses. “If rates [for the Barclays U.S. Aggregate index] were to go up one percentage point, that represents a 5% decline in price,” says Ken Leech, chief investment officer for Western Asset Management. “But a 5% decline is, by an order of magnitude, different from the losses you could see in stock [selloffs].” Last week’s Greek debt drama exemplifies this—bonds rallied.

Market-neutral funds (also known as long-short and absolute return funds) are designed to offer stability in turbulent stock markets. These funds, such as Vanguard Market Neutral (VMNFX) and TFS Market Neutral (TFSMX), use short-selling strategies to smooth out market volatility. “The idea with most of them is to offer performance properties similar to bonds,” says Josh Charlson, director of manager research, alternative strategies at Morningstar. The big difference, of course, is the source of stability. With these funds, he says, it comes from total return, not yield.

If your need for stability is attached to a specific goal or need, such as a tuition bill or down payment—and you need to access those funds within the next decade—you’ll want to take a different approach. If your time horizon is short, say one-to-two years, it’s probably best to stick with cash, since even short-term bond funds could experience losses in the near term.

RETIREES LOOKING for a place to stash five or 10 years’ worth of living expenses, though, run the risk of inflation outpacing the paltry returns on cash. What about hiding out in cash until rates go up? “That would be the right strategy if rates move up quickly,” says Leech. Of course, timing the bond market is even more difficult than timing the stock market. “Plenty of people have tried to capture interest rates and failed,” Leech adds.

A ladder of individual bonds may offer the best of both: stability and a systematic approach for trading up to higher-yielding bonds as your old bonds mature. “We don’t know when rates will go up, and it doesn’t matter to our clients,” says Weiner, who started moving his clients from bond funds into individual bonds in 2013. His model portfolio now calls for 75% of his clients’ bond holdings in individual bonds with laddered maturities; the rest is in short-term strategic bond funds.

This is no small commitment. You can get away with as little as $100,000 to ladder Treasuries, though some advisors will insist on more. A typical Treasury ladder might start at two years and go out to 10, with bonds maturing in two-year increments. At the current rates—1.25%, 1.77%, 2.07%, 2.21%, and 2.33% respectively—this ladder will average 1.57% per year for the first few years.

It’s just enough to keep pace with inflation, says Burns, and, as rates rise, the money used to buy each new rung of the ladder will be invested in higher-yielding bonds. If you’re looking for the higher yields of corporate bonds or the tax advantage of municipal bonds, you’ll need several times as much to achieve the requisite diversification.

Recognizing that many investors want the predictability of a bond ladder but the diversification of a fund, some firms have launched defined-maturity ETFs. These funds, such as Guggenheim BulletShares, are designed to mimic holding bonds to maturity—but these strategies still depend on your fellow investors staying put.

FOR INCOME SEEKERS, bonds are still the go-to asset for predictable payouts. Even while rising rates are ominous, the underlying demand for bonds remains strong. This is true of institutions and individuals, in the U.S. and the rest of the world.

At the same time, rates are even lower globally, and aging investors seem to be creating constant demand for bonds. “The rich are getting richer, and they’re getting older,” says Andy Chorlton, head of U.S. multi-sector fixed income for Schroder Investment Management, the United Kingdom–based asset-management giant.

That’s particularly good for tax-free municipal bonds, which offer relatively high after-tax yields.

Investors need to be choosy about credit quality, Chorlton says, but rising rates are less of a worry since municipal bonds tend not to move to the same extent as Treasuries. When rates do fall, so-called crossover buyers, or institutional investors who normally wouldn’t own tax-free muni bonds, move in and drive prices back up. “I don’t think investors need to fear rising rates in the muni market,” says Dawn Mangerson, a managing director at McDonnell Investment Management in Chicago. “One thing that helps keep a lid on yields is the supply of new issues, which is already limited and would likely dry up if rates rose in a meaningful way.”

Given that one of the biggest boosts for munis comes from their after-tax equivalent yields, your state of residence is a driving factor. If you live in a state with high income taxes and a large muni-bond market, such as California or New York, there are more opportunities and incentives to go this route.

High-yield muni bonds are also worth considering, says Merrill’s Sharma, if you are looking for income but can withstand some volatility. “With the improving economy, there is less risk of defaults,” he says.

Meanwhile, their yields—recently about 4.5%—dampen the blow of rising rates. Given their complexity, these are best bought through a bond fund, such as the Delaware National High-Yield Municipal Bond (CXHYX) or the Nuveen High-Yield Municipal Bond (NHMAX).

FOR YOUNGER INVESTORS—and older ones, too—there is an appeal in the keep-it-simple approach of taking some bond risk off the table. Hold more cash or cash-equivalents (for example, ultrashort-term bond funds) than you would typically, and keep the rest in a diversified portfolio of stocks, including dividend payers.

“You’re getting a bit of a yield—and it’s commensurate with bonds—yet over the long term, the values of those securities will likely increase and so too should the dividends,” says Johnson. Indeed, the current dividend yield on the Standard & Poor’s 500 is 2%, and companies ranging from Johnson & Johnson (JNJ) to Wal-Mart Stores (WMT) have consistently raised their dividends for decades.

This isn’t to say that dividend-paying stocks aren’t vulnerable to rising rates. Any income-producing asset could lose value if higher-yielding alternatives come on the scene. Still, the prices and dividends of these stocks are more closely linked to their own prospects.

Jeremy Kisner, a certified financial planner with Surevest Wealth Management in Phoenix, notes that dividend growers may do better than those focusing on the absolute highest-dividend stocks. More importantly, consider the effects of rising rates on the underlying businesses, for better or worse. Rising rates bode well for most financial stocks, says Kisner.

“When rates go up, that’s good for banks, which are still trading at a discount,” he says. Utilities, conversely, could be hit with a double whammy from rising rates: At the same time that their dividends will be less appealing, they are large consumers of debt. “Some stocks that were traditionally thought of as stable could be more volatile,” he adds.

For investors who want income but don’t want to have to think through all of the many considerations, the fund industry has responded with so-called income-builder funds, such as the Franklin Income (FKINX) or the Thornburg Investment Income Builder (TIBAX). “If you don’t have time to put together your own bond proxy,” says Merrill’s Sharma, “income-builder funds will effectively do it for you.” Just keep in mind that they won’t do everything.