Generate Income While Managing Risk Wisely

Bonds Article

Charles Schwab & Co., Inc.

Call us at 866-232-9890

Send us an email

Printer-friendly
Type Size: A A A
Email to a friend

Generate Income While Managing Risk Wisely
by Rob Williams, Director of Income Planning, Schwab Center for Financial Research
April 23, 2009

Reprinted from the April 2009 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

Risk being pegged too low contributed to current economic troubles, but we see opportunities now in which risk may be priced too high.
There's a strategy that may allow you to take advantage of current opportunities in fixed income markets.
Think about your income portfolio in terms of segments: an anchor, a core and a more opportunistic portion.

For nearly every investor, the stock market has felt like an elevator in free fall to the bottom floor. It's bounced back recently, and you may want to stay on board, but by now stability and income are starting to seem pretty appealing. Unfortunately, interest payments (yields) on the perceived safest investments, such as U.S. Treasury bills or money market funds, are at record lows. Meanwhile, yields on riskier investments are through the roof—but for good reasons.

Due to the big drop in the stock market, bonds have actually returned more during the past 10 years than stocks. And extreme stock market volatility has been tough—especially for those nearing or in retirement. Is there a place for stability, while optimizing strong, steady income in your portfolio? Let's take a closer look.

Yield is the price of risk
In financial markets, yield is the return on an investment through regular interest payments, and (for bonds) the return of your original investment at maturity. Yield varies based on market interest rates (which start with the Federal Reserve's federal funds rate) and the overall market perception of how risky the security is.

Investors generally demand higher yields for assuming greater risks than what they'd incur with short-term Treasuries, such as the possibility of default (non-payment), the inability to sell a security easily if needed, or the risk that the investment won't be worth as much as new bonds if interest rates rise.

The current economic difficulties are due in part to the price of risk—for mortgages, bank loans, consumer credit, derivatives, credit default swaps, etc.—being pegged too low. Now, we see some opportunities arising in which risk could be priced too high.

But don't go out and just look for yield, and yield alone. Higher-yielding securities tend to fluctuate much more wildly in price than those with more modest yields, since investors demand higher returns for taking on greater risk.

Even if you plan to hold individual bonds until they mature (i.e., when the principal is repaid) but wind up needing to sell before then, the market price may have dropped below what you paid initially. Can you stomach these risks? For many investors, recent markets have revealed their true risk tolerance.

There's a more pragmatic approach that can help you benefit from the risks and rewards of income investing. This strategy may allow you to take advantage of current opportunities in fixed income markets, while hopefully generating competitive returns and helping stabilize your portfolio.

Start with a plan
As with diversification of a stock portfolio, it makes sense to diversify an income portfolio. We recommend that you think about your portfolio in terms of segments: an anchor (for stability), a core (for market returns), and finally, a more opportunistic portion (to potentially add additional returns). Such a strategy may help optimize the balance between risk and reward.

The basics—low risk for the income anchor
For an investor who doesn't want to take too many chances—at least for what's meant to be the conservative part of his or her portfolio—we'd suggest roughly one-third of an income-generating portfolio be allocated to solid anchors. Many securities can serve this role, though at any given time some are more attractive than others. Here's a list, and how we feel about them now.

Short- to intermediate-term Treasuries can definitely offer safety for your principal, but current low yields are providing very little value now. Still, Treasuries create a solid anchoring position, and you can roll over principal at maturity—or a good fund can do it for you—into higher-yielding securities if interest rates rise.
Treasury Inflation-Protected Securities (TIPS) currently look like a better deal than Treasuries as part of your anchoring position, especially if you're concerned about inflation. The coupon rate (the percent paid in interest) remains fixed, but principal value is adjusted based on changes in the Consumer Price Index.
Short- to intermediate-term municipal bonds currently provide good value, in our opinion, for higher-income investors in taxable accounts. Muni returns continue to exceed those of comparable Treasuries, a rare historical occurrence.

Why not longer-term investments? Because they usually provide higher yields, their prices change much more dramatically if interest rates rise. For example, long-term Treasuries yielded 1.2%, on average, above short-term Treasuries during the past 20 years, but their price fluctuation was twice as high. Rates may not move dramatically higher soon—but they can't go much lower.

Build the core—adding yield with risks you can stomach
Conservative investors might do fine allocating up to 100% to basic anchoring investments, especially if they're looking to balance riskier stock investments. But for investors seeking yield, the basics are not going to be the entire solution.

An income portfolio's core positions seek to add income without significantly increasing risk. Consider allocating roughly half of your income allocation to these investments. Consider these options:

Intermediate-term (total market) bond funds can provide a good mix of diversification and management expertise, and they move into sectors with the best current prospects.
Investment-grade corporate bonds may provide opportunities now, as you can see in the chart below. Yields have come down a bit since spiking last year, but they are still quite high versus comparable Treasuries, even for high-quality companies.

Further allocation to intermediate-term munis—again, especially for high-income investors in taxable accounts. Seek to extend maturities a bit for the core, focusing on intermediate-term (three- to seven-year) individual bonds or intermediate-term funds.

Room to explore opportunity and risk—in moderation
Now for the fun (albeit riskier) part. We suggest you limit this to a maximum of 20% of your fixed income allocation. Keep in mind that these higher-risk investments will fluctuate more in value. We also think you should limit investments here to a proven, well-diversified mutual fund or funds.

Here are some investments to consider exploring:

High-yield (or "junk") bonds have recently been priced assuming a depression, but we don't think we're going there. Yields have spiked, meaning the previous prices have dropped—more sharply than seems justified by potential defaults, in our opinion.
Emerging-market bonds have also seen yields spike recently. Emerging-market stocks have shown strong returns in the first quarter this year, hinting that bonds may also fare better. You may also gain some protection if the dollar falls in value relative to other currencies.
Other choices to consider include closed-end bond funds and preferred stock, though both have been battered recently and involve unique risks and rewards.

It's all about balance
To help get started on your research, see the table below for general guidelines and what we think might be some current values. For more on choosing between individual bonds and bond mutual funds, read Jim Peterson's Bonds or Bond Funds? article.

Maintain your balance
Segment	Choices	Value in Sector Now?	Possible Mutual Fund Solutions
Anchor: Roughly one-third	Short-term U.S. Treasuries
	Intermediate-term U.S. Treasuries	Yes	CPTNX, FICMX
	Short-term muni bonds	Yes	STSMX, FSHIX
Core: Roughly half	Intermediate-term bond funds
	Corporate bonds	Yes	PTTDX, MWTRX
	Intermediate-term muni bonds	Yes	TWTIX, NOTEX
	TIPS	Yes	ACTIX
	Agency and government mortgage-backed securities
Explore: No more than 20%	High-yield corporate bonds	Yes	JAHYX, PHYDX
	International bonds	Yes	LSBRX
	Emerging-market bonds	Yes	PYEMX
	Preferred stocks
	Closed-end funds

The table below shows return data for many of the income sectors that we've discussed. Notice how those with the highest returns over time have, not surprisingly, incurred the greatest risk (as measured by standard deviation of total return).

Returns and risks for fixed income alternatives, 1989 through present
Instrument/Index	Current Yield to Maturity	Median Yield to Maturity	Median Total Return	Maximum Total Return	Minimum Total Return	Risk*
U.S. Aggregate Bond Index	4.2%	5.1%	7.4%	18.5%	-3.7%	4.6
U.S. Treasury	1.9%	4.1%	7.8%	18.4%	-4.5%	4.9
1- to 5-year Treasuries	1.1%	3.3%	6.9%	13.0%	-9.0%	3.5
Intermediate-term Treasuries	1.6%	3.9%	7.5%	14.4%	-1.8%	4.0
Long-term Treasuries	3.5%	4.8%	9.8%	30.7%	-11.6%	8.1
TIPS	n/a	n/a	6.4%	19.3%	-7.5%	5.3
Government-related agencies	3.0%	5.5%	6.3%	19.5%	-3.9%	4.4
U.S. mortgage-backed securities	3.8%	5.5%	7.4%	16.9%	-1.6%	4.1
U.S. corporate bonds	7.8%	5.8%	7.6%	22.2%	-13.8%	6.0
High-yield corporate bonds	18.1%	9.2%	7.8%	48.7%	-31.2%	11.4
Emerging-market bonds	10.0%	9.5%	11.5%	36.7%	-26.0%	12.3
Municipal bonds	n/a	n/a	6.7%	18.9%	-5.3%	4.3
Source: Barclays Capital Indexes, as of April 8, 2009. Figures are median of 12-month rolling averages. Total return defined as coupon payments plus changes in price. *Risk defined as standard deviation of total return.

Bottom line
In the end, we can all forecast, hypothesize or guess about what today, tomorrow or the next day may bring for the stock market or interest rates or the dollar. But these days, there may be comfort in cold, hard cash—and hopefully a bit of consistent income as well.

For help finding healthy income solutions, call 800-626-4600 to speak with a Fixed Income Specialist or contact your Portfolio Consultant. For other non-bond options for your portfolio, see the Income Mutual Fund Select List™ or log in to Schwab.com and go to Trade > Bonds.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

The current and future portfolio holdings contained in a mutual fund are subject to risk you should be aware of prior to making an investment decision. Past performance is no guarantee of future results, and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.

An investment in a money market fund is neither insured nor guaranteed by the FDIC or any other government agency. Although the fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in the fund.

All indexes used for data in the "Returns and Risks for Fixed Income Alternatives, 1989 Through Present" table are from Barclays Capital: U.S. Aggregate Bond Index, U.S. Treasury Index, U.S. Treasury: 1 – 5 Year, U.S. Treasury: Intermediate, U.S. Treasury: Long, U.S. Government Inflation-Linked Bond Index, U.S. Government-Related Bond Index, U.S. MBS Index, U.S. Corporate Bond Index, U.S. Corporate High-Yield Bond Index, Global Emerging Markets Bond Index and Municipal Bond Index.

Charles Schwab & Co., Inc. receives remuneration from fund companies for recordkeeping, shareholder services and other administrative services for shares purchased through its Mutual Fund OneSource® service. Schwab also may receive remuneration from transaction-fee fund companies for certain administrative services.

Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors. Changes in interest rates can affect a bond's market value prior to call or maturity. In addition, bonds incur ongoing fees and expenses. When a bond is purchased or sold, Schwab charges a commission, markup or markdown.

Municipal bonds may be subject to capital gains taxes, and interest income may be subject to the alternative minimum tax.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

International investments are subject to additional risks such as currency fluctuation, political instability and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Certificates of deposit are offered through Charles Schwab & Co., Inc. CDs from Schwab CD OneSource® are issued by other FDIC-insured institutions, and are subject to change and system access. Unlike mutual funds, CDs offer a fixed rate of return and are FDIC-insured. There may be costs associated with early redemption and possible market value adjustment.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. All expressions of opinion are subject to change without notice in reaction to shifting market conditions.

Past results are not indicative of future performance. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

(0409-8228)

Return to Top

Market Insight Alert Email

New Schwab commentary every two weeks:

Monday: Liz Ann Sonders
Thursday: Schwab Sector Views
Friday: Schwab Market Perspective

Clients can sign up now

Learn more

Income Mutual Fund Select List^TM