Don’t Abandon Bonds in Your Quest for Higher Yield

by Dan Burrows | May 16, 2013 6:45 am

To everyone who’s jumping into junk bonds, preferred shares, REITs, master limited partnerships and other high-yielding securities, be forewarned:

Federal Reserve Chairman Ben Bernanke is watching you.

And he should. Not only does the stampede into higher-yielding assets have the potential makings of a bubble one day, it’s no way to construct a well-balanced portfolio, says Francis Kinniry, a principal in Vanguard‘s investment strategy group.

The Fed chief has made it clear that the central bank is keen for any signs of irrational exuberance in REITs, MLPs, preferreds and all the rest of these tempting high-yielders. As Bernanke said in a speech last week:

“In light of the current low interest rate environment, we are watching particularly closely for instances of ‘reaching for yield’ and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals.”

True, as a fixed-income investor, you’re probably saying, “But, Ben, what the hell am I supposed to do?” The Fed’s ultra-low rate policy has benchmark 10-year Treasury notes throwing off less than 2%. A broad index of the most active investment grade corporate bonds shows them squeezing out only a bit more than 3.2%. Even junk bonds aren’t offering much in the way of yield anymore. Demand has pushed prices up so far that the yield on Merrill Lynch’s benchmark junk bond index fell below 5% last week for the first time in history.

Fixed-income investors are simply starved for yield. No wonder they’re diving into junk, MLPs, REITs and anything else that can deliver 300 or 400 basis points above expected inflation.

But this hunger for yield could be very dangerous indeed. As tempting as all those higher-yielding securities might be for fixed-income investors, they are in no way a replacement for bonds in the totality of your portfolio.

Why? Because those scrumptious high-yield securities provide no ballast to your holdings in a market downturn.

In a recent Vanguard research and commentary piece, Kinniry made the critical point that things like preferreds and MLPs will not act like bonds — that is, add buoyancy to your portfolio — when the equity markets sell off:

“Our research cautions investors against replacing a broad bond allocation with higher-yielding assets. While these may increase the portfolio’s yield, they are more highly correlated with equities in market reversals, when investors are most in need of a cushion against volatility.”

In other words, when stocks go down, these higher-yielding securities will very much go along for the ride.

Prices of preferred shares, for example, aren’t supposed to move all that much. It’s a security that gives a shareholder first dibs on a company’s future dividends — not its future earnings.

From peak to trough during the last crash, the market lost more than 50% of its value — but preferreds fared even worse. The iShares U.S. Preferred Stock Index ETF (NYSE:PFF[1]) lost nearly 70%.

Bonds, however, held up magnificently well. They were hardly correlated at all. The Vanguard Long-Term Bond Index (NYSE:BLV[2]), for example, declined by less than 2% during the stock market crash.

That’s why a portfolio of uncorrelated assets is critical for better risk-adjusted returns over the long haul. When equities are sinking, boring old low-yielding, low-volatility bonds can be your portfolio’s life jacket. Says Kinniry:

“A broad allocation to investment-grade bonds has offered low correlation with stocks in bear markets, resulting in significant downside protection when stock returns were negative.”

By all means, allocate a part of your holdings to higher-yielding securities — be they preferreds, generous dividend payers, REITs or MLPs — if you are so inclined.

Just don’t fool yourself that these are in any way substitutes for stalwart debt securities in your long-term, risk-adjusted portfolio.

As of this writing, Dan Burrows did not hold positions in any of the aforementioned securities.

  1. PFF:
  2. BLV:

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