The Risk of Safety – Wall Street Journal – 01/26/13

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The Wall Street Journal

Weekend Investor – January 26, 2013

Weekend Investor

The Risk of Safety

With bond markets near all-time highs, investors face tough times ahead.

Here’s how to avoid the damage – and maybe even profit.

By Joe Light

Safety has rarely been more expensive—or more dangerous.

For the past five years, the Federal Reserve has pushed down the interest rates on traditionally safe assets such as Treasury bonds to near record lows, in hopes of sparking the economy. Today’s 10-year Treasury rate of about 1.95% is about half its level in January 2008.

Rock-bottom rates hurt retirees investing for income—and create a dilemma for the millions of savers who rely on bonds to steady their stock portfolios. Bond prices move in the opposite direction of yields, so when prices fall, yields climb. With prices near record highs, even a small move can produce losses for investors.

The trouble now: With yields near record lows, bond prices seem especially ripe for a fall. While bonds should still be steadier than stocks, their returns won’t be nearly as robust, experts warn.

Along with all bonds, traditionally “high risk” investments, such as high-yield corporate bonds and emerging-market government bonds, have seen their yields plummet as investors have piled in.

Countries that issue such bonds right now make up about 40% of the world’s gross domestic product but issue only 10% of its sovereign debt, meaning they should have ample revenues to pay the bonds.

Comments January 26, 2013

Building a well diversified portfolio of individual government or corporate bonds can easily require $1 million or more.  The exercise becomes more complicated and more costly as investors diversify across the credit spectrum in search of higher yields both domestically and internationally.   Investors must pay close attention to the litany of covenants among the tens of thousands of bond issuers.

Mutual funds can provide one-stop diversification.  Passively managed index funds generally weight their portfolios toward the most leveraged bond issuers, even if the risks of those issuers can overburden their ability to make future interest payments and pay back the bonds.  Actively managed funds can choose the most attractive bonds based on yield, duration, credit risk, favorable covenants and a host of other factors.  Actively managed funds can increase or decrease holdings and add or eliminate holdings as markets fluctuate and present market inefficiencies.

Although on a stand-alone basis international investors may face additional risks, such as less liquidity, political volatility and currency fluctuations, the addition of international investments to a well diversified domestic portfolio can actually increase overall returns and simultaneously reduce risk.

Aaron Skloff, AIF, CFA, MBA
CEO – Skloff Financial Group

Aaron Skloff, Accredited Investment Fiduciary (AIF), Chartered Financial Analyst (CFA), Master of Business Administration (MBA), is the Chief Executive Officer of Skloff Financial Group, a NJ based Registered Investment Advisory firm. The firm specializes in financial planning and investment management services for high net worth individuals and benefits for small to middle sized companies.  He can be contacted at www.skloff.com or 908-464-3060.

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