Think of it this way: When do investors need diversification? Do they need it during bull markets? Absolutely not. In fact, when stocks are rallying, they would do better to concentrate their holdings in high-octane, high-beta assets.
The time investors really need diversification is when the markets turn, and they’re looking for uncorrelated assets to buffer portfolio volatility. And guess what? High-yield bonds will probably not do that job very well. The same goes for floating-rate bank loans, by the way.
OK, now that we have all the ominous warnings out of the way, here’s the ironic punch line: Investors can probably avoid all the pitfalls we’ve discussed if they just maintain discipline and refrain from making knee-jerk decisions when they suffer short-term losses.
Sure, the stock market can correct sharply and high-yield bonds can follow along, causing deep, painful portfolio losses for a number of months. If they choose to sell their high-yield bonds after the correction, they lock in their losses. For instance, selling high-yield bonds at the end of 2008 would have resulted in a loss of -26.2 percent over the prior 12-month holding period.
However, if they had chosen to hang on to those investments, they would have realized significant profits in their high-yield bonds by year three.
In most cases, over the long term, nearly all total returns generated by diversified bond portfolios come from their income. Bonds are issued at par and mature at par. So long as defaults are not significant, cumulative returns are a function of the amount of income distributed and the investor's holding time.
How does investor discipline factor into the equation?
If investors have the discipline to avoid the temptation of bonds that could produce short-term losses greater than they can handle, or be willing to continue holding bonds that have delivered painful short-term losses, they can generate solid returns regardless of fluctuations in the broader markets.
Sage, an independent investment management firm, serves institutional and private clients with traditional fixed-income asset management and global tactical ETF strategies. Sage began using ETFs in 1998, and today offers a range of tactical all-ETF solutions, including income-focused and target-risk global allocation strategies. Contact Sage at 512-327-3330 or sageadvisory.com.