It feels like deja vu all over again, as investors reach for an extra 50 bps (0.5 percent) yield while forgetting the painful losses of 2008. Yet I would argue that, if done right, one can build a fixed-income portfolio with that extra yield and even have less risk. Let me explain.
First and foremost, bonds should be boring and the stabilizer of one’s portfolio when stocks plunge. According to Morningstar, the average bond fund lost 8 percent in 2008, just when we needed our bonds to act as the portfolio shock absorber. Though many bond funds lost more than stocks, a high-credit-quality fund such as the iShares Core Aggregate Bond fund (AGG | A-98) gained 5.88 percent net asset value (NAV) that year, and the price did even better.
Today that bond fund yields 2.01 percent, is 62 percent U.S. government-backed and has a duration of 5.3 years. Thus, if interest rates rose 1 percentage point instantaneously, this fund would lose about 5.3 percent. Rather than take on credit risk that will likely be correlated with stocks, a better fixed-income portfolio can be built with two types of certificates of deposit (CDs). Here’s an example ...
Building A Better Portfolio In 2 Steps
Let’s say you have $100,000. The following are the steps to build a fixed-income portfolio yielding 2.62 percent, that is 99 percent government backed and with a duration of about 4.6 years.
Step one: Take half the money and buy a five-year direct CD from a bank like Barclays Bank. It yields 2.25 percent, and has a low early-withdrawal penalty of 180 days’ interest. That amounts to a 1.12 percent penalty that you can think of as a put giving the right to sell it back at that discount. So, arguably, the duration is 1.12 years. It’s also 100 percent FDIC insured. This is a low risk way to get high yields.
Step two: Take the other half and buy a brokered CD on the secondary market. Though a little more complex, I’ve explained in more detail that your broker may have the best CD deals. Recently, brokered CDs having about nine years remaining were yielding just over 3.0 percent. That maturity equates to about an eight-year duration. Brokered CDs are also FDIC insured up to par value. Considering that rates have declined, these CDs are often selling at a premium, and perhaps 1 or 2 percent of the purchase price is uninsured. Let’s call it 98 percent FDIC insured.
Finally, don’t make the mistake of thinking this has no interest-rate risk because it will mature at par. Bonds have as much risk as bond funds. Because this CD has a longer duration than AGG, it has more interest-rate risk.
Your New Portfolio: Pros & Cons
Put the two parts together and, voila, you end up with a fixed-income portfolio yielding 2.62 percent, that is 99 percent U.S. government insured, and that has a duration equivalent of about 4.6 years. All of the extra 0.61 percent yield over AGG comes from FDIC insurance that is meaningful to most investors but accounts for rounding error for institutions like Goldman Sachs.
So on paper, you get greater yield with less default and interest-rate risk than AGG. Still, there are two downsides—less liquidity and more active management. Though AGG can be sold pretty close to NAV, neither the direct nor brokered CD can. As mentioned, closing out the direct CD costs 1.12 percent before maturity, and brokered CDs have commissions and spreads when they are sold.
The second downside of active management applies only to the direct CD. One must pay attention and be willing to close the CD and pay the penalty if rates go up. Otherwise, the value of the put is lost.
Roughly 70 percent of my fixed income is in CDs using this strategy, though most in the direct CDs. It’s easily worth the little extra time, in my view. This will be especially true if interest rates really do go up. After all, economists can’t always be wrong in forecasting rates.
Higher yield with less risk is a good thing. This strategy is better than bonds.
Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for AARP publications.