What's surprising to many pundits and investors is that the market continues to be strong with pullbacks along the way, and that there's continuing strength in growth sectors, such as the Internet and solar energy sectors. Underlying skepticism from the public seems to be keeping the market from gaining too much ebullience and helping the market climb a wall of worry. Reasonable valuations, low interest rates, and a growing global economic stability are the underpinnings for the market; these factors are doubted by many investors. And the people on the sidelines grow ever more doubtful as the market moves higher. Many people have their money in bonds -- and bonds could be a very risky asset class, especially bond funds. Bond prices have probably seen their highs.
Raul Elizalde of Path Financial LLC -- a money
manager that builds and manages portfolios that focuses on diversification, periodic rebalancing and downside risk control -- writes in a recent report that interest rate declines for the last 30 years have made people believe that fixed-income securities are generally safe. In fact, portfolios that have a heavy exposure to bonds are considered to be conservative. But at some point, interest rates will probably rise, and the pace of their rise can catch bondholders unawares. In many cases, the rapid depreciation on the principal side that can occur to fixed-income instruments might surprise many holders.
Elizalde writes that interest rate cycles are long and dramatic. Interest rates rose from 1898 through 1920, a 22-year cycle. They dropped from 1920 through 1940, a 20-year move. From a low level in 1940, interest rates rose to historic highs in 1981, upsetting the economy and the stock and bond markets. I remember that time well. The stock market was being regarded as too risky, and its time as a good place to put money was past, with stock price/earnings ratios scraping along at four to six times earnings levels. I don't recall seeing these multiples again until the lows of 2009. On the fixed-income side, the US Treasury note in 1981 was paying over 15%. This high interest-rate level set up the greatest bull bond market in history, as yields dropped from over 15% to about 1.5%. Interest rates dropped to historic lows in 2012.
"Barring deflation," Elizalde espouses, "these low levels will not be around again for a long time." He finds that the highest risk that investors face is with bond funds. With bond funds, "managers almost never hold bonds to maturity. This is because bond funds are typically defined by maturity targets (short term, intermediate term, and so on), and as time goes by, holdings are rebalanced to keep the fund's average maturity constant. To do so, managers replace shorter ones with longer ones constantly, booking losses if interest rates go up because they sell bonds that were acquired at higher prices, when interest rates were lower. They buy high and sell low. Thus bond funds don't have the certainty of payments that comes from holding a bond to maturity."
Elizalde employs a process that offers solutions to traditionally built portfolios -- those that often contain substantial allocations to bond funds.
An ETF Family for Fixed Income
One solution for fixed-income investors is defined-maturity bond ETFs. Buying short-term fixed-maturity date ETFs takes away some of the risk of buying long-term bonds. The interest rate risk is taken away, if you can hold the ETF to maturity. There's still credit risk, but that risk is ameliorated due to the short term that one has to hold the ETF. Also, there's diversification, since each ETF holds more than 100 bonds.
One provider is Guggenheim, which offers its BulletShares family of ETFs. These ETFs have fixed maturity dates, and if an ETF is held to maturity, the holder will receive the proceeds from the bonds. The BulletShares family of ETFs holds US dollar-denominated bonds. There are two series of bonds offered: an investment-grade corporate bond portfolio selection, and a high-yield investment-grade selection. BulletShares pays monthly interest payments to ETF holders.
Market-Linked Certificates of Deposit Backed by US Government FDIC Insurance
An even safer way to invest than holding bonds to maturity and hoping the bond issuers will be able to make the principal payments is by buying market-linked certificates of deposit (MLCDs). MLCDs are safer, though it cannot be said that they're totally safe. However, the only risk in these debt instruments is that the US government will not or cannot pay when the CDs mature, and the issuing bank can't make the principal payment.
You might scoff at the idea that the US government wouldn't have the ability or desire to pay its debts -- but how short our memories are. Only five years ago, at the height of the worldwide financial meltdown, investors were staring at this very possibility, and with good reason. Hopefully this situation won't come back, but the fact is that the specter of this happening again makes me write that government-backed MLCDs are low risk but not without
I'm referring to those MLCDs that are FDIC-backed. Not all MLCDs are FDIC-insured. MLCDs are constructed to participate in many different markets, including commodities, emerging markets, and other asset classes that may be or may not be correlated to the US stock market. Many of these CDs have a "survivor option." If the CD holder dies, her heirs can redeem the CD at par. MLCDs are structured by major banks such as Union Bank and Goldman Sachs and can be bought from those banks and from stockbrokers and financial dealers.
Another way to get stock market exposure is through market-linked annuities. Annuities are contracts between the annuity owner and an insurance company. Annuities are designed to provide an income stream immediately or in the future. Not all annuities are market linked, and those that are have varying degrees of participation in market moves. Read the annuity document carefully to understand its features.
Editor's Note: Max Isaacman is the author of Blizzard of Money, Winning with ETF Strategies, Investing with Intelligent ETFs, How to Be an Index Investor, and The NASDAQ Investor.