Are higher yield bonds a wise investment for you

December 31, 2012

Depending on your approach, pursuit of higher yield bonds may invite more risk, some of which may be hard to see or understand.

Q: With interest rates so low, does it makes sense to invest in higher yielding bonds?

A: Fixed-income investments, such as bonds, can play an important role in a portfolio. The current environment of historically low interest rates has sent many investors on a quest for higher yield bonds or alternative investments. Depending on your approach, this pursuit of yield may invite more risk, some of which may be hard to see or understand.

When interest rates rise, the value of an existing bond declines; when rates fall, existing bond values rise. The market adjusts a bond’s price to match the yield available on a new instrument. Investors who hold fixed-income securities with longer maturities are exposed to the amplified effects of term risk. A long-term bond is more exposed to rate changes than a short-term instrument and usually (but not always) offers a higher yield to compensate investors for the extra risk.

So what’s an investor to do? How can you make prudent fixed-income decisions while also addressing today’s low interest rates? Consider these principles:

Remember how markets work. The same core investment principles apply in any market environment. One key principle is that in a well-functioning capital market, securities prices reflect all available information. Today’s bond values reflect everything the market knows about current economic conditions, growth expectations, inflation, Fed monetary policy, and the like. So, according to this principle, the possibility of rising interest rates is already factored into fixed-income prices.

Rather than trying to predict macroeconomic forces that are difficult to foresee, investors can look to the market to set prices and focus on the variables within their control.

Start with a clearly defined goal. Fixed-income choices should follow a broader investment strategy that defines the role of fixed income in a portfolio. The portfolio can then be customized to meet those specific goals while managing tradeoffs.

An investor who wants to avoid losing market value might have a different fixed-income allocation from someone who wants to take a balanced approach, needs immediate income, or is seeking higher returns. Investors with different objectives typically have different tradeoffs regarding risk, expected return, and costs.

Understand the tradeoffs. When reaching for higher yield, investors should carefully consider the potential effects of their decisions on expected portfolio performance and risk. In the fixed-income arena, investors have two primary ways to increase expected yield and returns on bonds. They can extend the overall maturity of their bond portfolio (take more term risk) or hold bonds of lower credit quality (take more credit risk).

These may be reasonable actions. But pursuing higher income means accepting more risk, as measured by interest rate movements, price volatility, or greater odds of losing value if the issuer defaults.

Consider expanding to a global fixed-income strategy. Investors have other tools to enhance risk and expected returns in fixed income. You can expand your opportunity for success by moving beyond your domestic fixed-income market to access yield curves in other countries’ markets. By owning bonds issued by governments and companies from around the world, investors can enhance diversification in their fixed-income portfolios.

No one really knows when and by how much interest rates will change. Investors looking for higher bond yields should understand the higher risks tied to their decisions. Most investors might be best served by building a fixed-income strategy to complement their broader portfolio objectives, understanding the sources of risk and expected return.

Q: For 2013, are there any changes to retirement plan contribution limits and annual gifting limitations?

A: Yes, once again, the limits have been raised for many, but not for all of the plans. The annual gift tax exclusion has been increased from $13,000 to $14,000 for 2013. The 2013 IRS limits on 401(k) and 403(b) plan elective deferrals are being increased by $500 to $17,500. Unfortunately, catch-up contributions for those 50 and older will remain at the $5,500 level. The SIMPLE employee contribution limit will also be increased by $500, bringing that limit up to $12,000. For other plan limitations for 2013, visit the IRS website at www.irs.gov for more information.

Financial Tips

  • A long-term bond is more exposed to rate changes than a short-term instrument and usually (but not always) offers a higher yield to compensate investors for the extra risk.

  • Today’s bond values reflect everything the market knows about current economic conditions, growth expectations, inflation, Fed monetary policy, and the like.

  • Fixed-income choices should follow a broader investment strategy that defines the role of fixed income in a portfolio.

  • For 2013, the annual gift tax exclusion has been increased from $13,000 to $14,000, and the IRS limits on 401(k) and 403(b) plan elective deferrals are being increased by $500 to $17,500.

Send us your questions

Send your questions about estate planning,  retirement, and investing  to Joel M. Blau, CFP,  c/o Urology Times, at UT@advanstar.com.

Questions of general interest will be chosen for publication. The information in this column is designed to be authoritative. The publisher is not engaged in rendering legal advice.