10 Bond Portfolio Picks Before the Fed Cuts Rates

VaselineSeptember 10, 2024

0 5 minutes read

10 Bond Portfolio Picks Before the Fed Cuts Rates

The US bond market is about to enjoy the proverbial best of both worlds. Bond yields, an approximation of annualized bond yields, are high—the Bloomberg US Aggregate Bond Index yields 4.6%; US high-quality corporate debt, 5.1%. And interest rates are about to fall, which means bond prices will rise. (Interest rates and bond prices move in opposite directions.)

Together, this is a double advance on total bond market returns. “I think this is one of the best times to put money to work in the bond market in 20 to 25 years,” says Thomas Urano, managing partner at Sage Advisory.

So now is a good time to review your core bond portfolio. You can always start with a broad bond index fund such as iShares Core US Aggregate Bond (AGG, yield 4.5%), an exchange-traded fund that tracks the benchmark considered to be a barometer of the bond market. But “every investor has their own goals and risk tolerance,” says Invesco’s Jason Bloom. “Our view is that investors can do better – much better – than own Agg.”

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In fact, most active bond fund managers outperform the US Aggregate Bond Index over the long term, on average, according to fund tracker Morningstar. Our favorite active core bond funds, Baird Aggregate Bond (BAGIX, yield 4.2%), Dodge & Cox Revenue (DODIX, 4.7%) — a member of the Kiplinger 25, our favorite no-load mutual funds — and Fidelity Total Bond (FBND, 5.2%), have each outperformed Agg over the past one, three and five years. That’s why we prefer to start with an actively managed core bond fund – we let an expert do the hard work.

But it can be useful to supplement your core holdings with tactical tilts of exposure to certain bond sectors to improve performance. We’ll show you some simple ways to optimize your portfolio for current market conditions by leaning toward the bond sectors that are attractive now.

Of course, if you own shares of an active intermediate core bond fund, your manager may already be making some of these moves, so consider any changes to your overall portfolio. We’ve also included model portfolios, built by Elya Schwartzman at fund firm BondBloxx, as an example of how professionals could increase the return or decrease your portfolio’s sensitivity to interest rate changes. (Yields and other data are through July 31 unless otherwise noted.)

Mix the ingredients

To beat Agg, you’ll want the flexibility to strengthen certain sectors of your portfolio and de-emphasize others depending on the market environment. The main ingredients in an investment-grade bond portfolio are Treasuries, corporate debt and mortgage-backed securities, with a sprinkling of government-linked IOUs and asset-backed securities (such as credit card loans and auto loans ).

Start with Treasury. For now, it makes sense to focus on Treasuries with maturities between one and 10 years. Although price declines from rising interest rates are largely in the rearview mirror, many bond experts still favor short- and medium-term government bonds, which are less sensitive than long-term debt to interest rate changes.

But the yield curve remains inverted, meaning that shorter-dated bills yield more than their longer-dated counterparts. And when rates start to fall, bond analysts expect yields to fall more on the short side. “We prefer the short term because we like the high current yield and safety,” says BondBloxx’s JoAnne Bianco. “And medium-term bonds can still capture potential price returns when the Federal Reserve cuts interest rates.”

Funds worth exploring include SPDR Portfolio Short Term Treasury ETF (SPTS), which currently yields 4.6% and has a duration (a measure of interest rate sensitivity) of 1.8 years. This means that if rates fall by one percentage point, the fund’s net asset value will increase by 1.8%. Or consider Schwab Intermediate-Term US Treasury ETF (SCHR), which yields 4.3% and has a duration of five years.

Tap into high quality corporate debt yield. “Adding your exposure to triple-B corporations is a good way to improve long-term returns,” says Bianco. Triple-B corporate bonds are still investment grade, but offer better yields than higher-grade corporate debt and also have better long-term returns. The trade-off is higher volatility. Over the past decade, triple-B corporate debt has been 10% more volatile than the broader corporate debt market.

If you can handle the added volatility, consider it iShares BBB Rated Corporate Bond ETF (LQDB), which yields 5.3%. The fund has returned 7.1% over the past 12 months.

Add quality to your bond portfolio with a higher dose of mortgage-backed and asset-backed securities that offer compelling returns. Mortgage bonds may get a boost when rates fall and the home loan refinancing machine picks up, says Sage Advisory’s Urano. The Vanguard Mortgage Backed ETF (VMBS) charges just 0.04% in expenses, has a yield of 3.8% and boasts an average triple-A credit rating. The fund has returned 5.1% over the past year.

Many bond experts like asset-backed securities these days, especially credit cards and auto IOUs. “They’re high-quality, triple-A-rated bond investments with maturities of less than three years,” says Urano. Few funds focus exclusively on such titles, but we like the look ETF Virtus Newfleet ABS/MBS (VABS). The active ETF is small ($9 million in assets) but invests in high-quality, short-term asset-backed and mortgage-backed securities. Over the past year, its 8.3% return has outperformed 92% of all short-term bond funds. It has a yield of 5.0%.

Adventure beyond Agg

One trick managers of medium-term winning core bond funds often use is to dip into the junk bond market, which is not represented in Agg. These low-quality corporate securities have a higher risk of default and are more volatile. But over the past decade, they have returned 4.6% annually, outpacing the 2.6% growth in investment-grade debt.

“Many people shy away from high-yield debt because they are risk averse in their bond portfolio,” says Bloom. But “historically, over the course of the economic cycle — recovery, expansion, slowdown and recession — high yield is the only sector that has outperformed in every phase.”

Reduce your junk bond risk by keeping your stake low — say 3% of your bond portfolio — and focusing on double-B rated debt, the highest quality level of high-yield bonds. The iShares BB Rated Corporate Debt ETF (HYBB) holds only double-B rated debt, yields 6.2% and has returned 10.0% over the last 12 months. The broad high-yield benchmark outperformed, returning 11.0%, but with higher volatility.

Note: This article first appeared in Kiplinger Personal Finance Magazine, a monthly, trusted source of advice and guidance. Subscribe to help you earn more money and keep more money you earn Here.

Model portfolios for bond investors

model portfolios for bond investors, courtesy of BONDBLOXX

(Image credit: Kiplinger)

VaselineSeptember 10, 2024

0 5 minutes read

Vaseline

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