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.