Corporate Bonds Make Good Portfolio Staples

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Corporate Bonds Make Good Portfolio Staples

By Martin Hutchinson, World Banking Analyst

What if I told you that it’s possible to achieve decent yields while also preserving your investment capital?

I bet you’d jump on such an opportunity in an instant, wouldn’t you?

Unfortunately, that outcome is very difficult to achieve right now. Stocks don’t provide a worthwhile yield, with the S&P 500 yielding just 2.1%. Meanwhile, specialized “income stocks” contain a number of snares and traps that can destroy our wealth.

What’s more, stocks always have the potential to take a nosedive like they did in 2008 to 2009. If they do, they become unsellable . . . because by selling, we’ll inevitably miss the rebound.

It’s quite a conundrum for income investors. Luckily, Corporate America is happy to provide us with a constant revenue stream for doing next to nothing…

Bond Benefits

Good, quality corporate bonds are a reasonable compromise for at least part of our money. In fact, there are two reasons why corporate bonds make sense as part of an income portfolio.

First, their yields are considerably higher than those of Treasury bonds. In fact, your income could be upwards of 50% greater, compared to 10-year Treasuries.

Second, while stocks are always vulnerable to a nosedive, corporate bonds are much less risky (provided they’re of a high quality). Hence, if you need to liquidate part of your portfolio at the bottom of the market, your corporate bonds will be available to sell at prices not too far below those that were obtained at the top.

Yet bonds aren’t entirely without risk, as investors must deal with duration and credit risk. After all, funds typically increase their yield to investors by increasing one of those two factors.

At present, long-term bonds yield substantially more than short-term bonds, so a portfolio of long-dated bonds gives you a much better yield than shorter-term bonds. The danger is that long-dated bonds decline much more in price when interest rates rise, giving investors a capital loss.

However, one collateral benefit of long-dated bonds is that a major stock price decline would probably cause the Fed to enter into a money-printing spree, lowering long-term bond yields and raising prices. Thus duration risk, unlike credit risk, isn’t highly correlated with stock price risk.

You should, of course, be cautious about taking on too much credit or duration risk. But of the two, I’ll take duration risk, and I’ll look for funds with a long average maturity/duration . . .  but a low percentage of the fund invested in bonds rated BB or less.

Finding a Fund

There are two ways to buy bonds: directly or through a bond fund.

Buying corporate bonds directly has two distinct advantages. First, it avoids the management fees of a bond fund. Second, if you have a particular cash flow need in the future, you can buy a bond to match it, which isn’t possible through a fund.

However, for individual investors, these advantages are outweighed by illiquidity and lack of price transparency. Unlike stock prices, bond prices aren’t readily available to individual investors. Consequently, there’s always a risk of buying too high and selling too low, losing much of the bond’s return.

Instead, investors can look to buy bonds through a bond fund. There are two principal types of corporate bond funds: closed-end and open-end. Some closed-end funds buy a fixed portfolio of bonds, so you know what you’re getting when you buy them. Others trade bonds seeking higher returns, just like open-end funds.

The disadvantage of closed-end bond funds is that they tend to trade at a discount to their net asset value. This gives you an advantage when you’re buying, but increases the liquidity risk when you sell – if closed-end funds are out of favor at that time, the discount will widen.

A broadly spread, closed-end fund such as BlackRock Credit Allocation Fund (BTZ) has its attractions. This fund invests beyond the corporate bond market, with positions in mortgage bonds and preferred debt, with about one-third of its assets in securities rated below BBB.

With a net asset value of $1.4 billion and a discount to net asset value around 12%, it represents good value right now, although the expense ratio of 1.15% is on the high side. The fund currently pays monthly dividends of $0.0805, giving it a running yield of about 7%. I’d regard it as a sound but relatively high-risk investment.

But given my preference for duration risk over credit risk, my recommendation among open-end bond funds would be the Vanguard Long-Term Investment-Grade Fund (VWESX), which offers a yield of 4.5% and, like most Vanguard funds, has low annual expenses of only 0.22%.

Since the fund has net assets of $15.8 billion, its liquidity is ample, and it has less than 2% of its investments in bonds rated below BBB. Its only disadvantage is a relatively long average duration of 12.8 years, making it vulnerable to a rise in interest rates.

Good investing,

Martin Hutchinson

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By Martin Hutchinson