"I sat there with two tens ... I thought I'd have some fun; The dealer hit 16 with a five... Just enough to make 21."
— from "Blackjack" as performed by Ray Charles
Astute retiree investors may want to reconsider the time-honored, classic 60/40 portfolio investment strategy. Since 2000, bonds have been anti-correlated with stocks, meaning that bonds went up when stocks went down. Investors owned bonds for income and also because they hedged a stock-laden portfolio.
But now, bond yields appear to be moving higher and the anti-correlation relationship has been skewed. In fact, bonds may be becoming non-correlated (meaning they’ve lost any relationship with stock movements) and in many cases have become positively correlated with stocks. This means that stocks and bonds can go up and down together. That’s not a problem when stock prices are rising, but should markets take a downturn, stocks and bonds that are positively correlated can fall simultaneously. In this environment, bonds may no longer serve as a hedge against portfolio loss.
If you were completely invested in stocks from late 2007 to early 2009, you lost more than half your money (the S&P 500 lost over 56 percent peak-to-trough), so holding bonds (which gained value over that time frame) would have mitigated losses. In a 60 percent S&P 500 index/40 percent aggregate bond index portfolio, an investor would have lost one-third instead of over one-half of his assets from October 2007 until the end of the downturn in March 2009. However painful, losing a third beats losing over half, so bonds served as an effective portfolio hedge at the height of the Great Recession.
Bonds can still be a serviceable portfolio component, especially if investors own individual bonds and keep the duration on them extremely short. Buying the best quality, high yield corporate bonds available, ones that mature within two to three years, allows you to enjoy some yield while maintaining maximum portfolio flexibility.
Investors may consider buying the short term bonds of companies whose stocks they might own in a risk-on environment and where the investor is first in line to get paid on the maturity ladder. It’s unlikely there will be major credit losses with a diversified basket of highly rated high yield bonds in the next two to 24 months. If an investor is getting over 4 percent on average on these bonds, he's probably doing well. If he steps up the yield to the 5-6 percent range for that under-24 month maturity range, he's likely taking a large degree of credit risk and the risk-adjusted marginal return may be unwise.
Preferred stocks are also one of the few places to get significant, predictable yield in today's market. Some can generate enough meaningful income to balance the interest rate risk that an investor may be assuming.
Margaret R. McDowell, ChFC®, AIF®, author of the syndicated economic column “Arbor Outlook,” is the founder of Arbor Wealth Management, LLC, (850.608.6121 – www.arborwealth.net), a “fee-only” registered investment advisory firm located near Sandestin.