Building resilient investment portfolios possible when return on bonds is low

No matter how your investments have performed recently, they are subject to a wide range of possible future outcomes that can shift quickly. Mixed signals for the outlook of the global economy, stocks, bonds, interest rates and other factors require your investment strategy to be resilient amid uncertain influences on performance.

Some people adapt their investments seeking the optimal portfolio to address current circumstances. It is significantly unlikely, however, for any chosen investment strategy to achieve the optimal outcome because it is hard to predict what the mix of conditions, opportunities and timing will be that leads to that optimal outcome.

Instead, what every investor can do is position their investments for an adequate mix of projected returns and risk management so that their strategy is robust during wide-ranging conditions for the economy, investment markets and investor sentiment.

Typically, the more resilient component of a diversified investment strategy is the bond portion of the portfolio. Bonds offer more stability than stocks, with the trade-off being lower return potential.

Lately, bond market returns have been about as low as they ever get. Through the end of November, the U.S. Aggregate Bond Index had a year-to-date total return of -1.3 percent. If that holds for the final month of 2021, this would be just the fourth calendar year since 1976 with a negative return for this index.

For investors reluctant to lean heavier into stock markets, there are some options to consider that might generate a bit more return from the defensive portion of their portfolio.

It has long been clear that professional managers of active mutual funds, or other investment vehicles, fail to beat passively held index funds a majority of the time. This is particularly true for stock funds, a little bit less so for bond funds. However, over the past year-plus, given the mix of circumstances impacting bond markets, active managers have burst forward with index-beating performance in far more cases.

Morningstar publishes an annual report reviewing the performance of investment managers. In the October 2021 release, which tracked performance through June 30, 2021, 85 percent of U.S. intermediate core bond fund managers outperformed their benchmark. They have had far less success over longer periods but, more often than for stocks, there are times when bond market indexes can be beaten. Active managers can make decisions about the duration/maturity of the bonds they own, the credit quality of the bonds they own, whether to invest in other types of bonds backed by mortgages or other assets and when to time their buy or sell decisions.

Reviewing performance (year-to-date through the end of November) of the 25 largest actively managed core bond funds (not funds that own short-term bonds or high-yield “junk” debt), just two of the funds have had a lower return than the U.S. aggregate bond index. The average return of the group provided nearly a 2-percentage-point edge over the index year-to-date. Lightening indexed bond holdings may be beneficial headed into 2022.

If you prefer to seek higher income from other sources, there are alternatives.

Series I U.S. savings bonds purchased before April 2022 pay 7.12 percent interest. This rate is adjusted for inflation every six months. It currently reflects the recent surge in inflation. The rate will likely be reduced in April. However, a 7-plus percent return even for a short period is way more than other bonds or bank savings vehicles will provide. There is a $10,000 per person per year limit on purchases of these bonds at TreasuryDirect.gov. You must wait at least 12 months to redeem the bonds. If you redeem within five years, you forfeit three months’ worth of interest. However, an investment with no costs that cannot decline in value is compelling.

People over 70 may consider single-premium immediate or deferred annuities for a portion of the money they currently have allocated to bonds. The available payout rate may provide more income than bonds currently do but possibly not forever since the annuity payouts are not typically adjusted. Charitable gift annuities available from many non-profit organizations may be particularly attractive if there is a desire to also achieve additional income tax benefits.

For people willing to expand the risk of their investments in exchange for higher income, commercial real estate funds offer more return potential than bonds, but with volatility in the principal balance that is more like stocks. Another form of higher income with a moderate uptick in risk is bond mutual funds that do not have daily liquidity. Often called interval funds, these are mutual funds that allow redemptions quarterly. Without the need to maintain daily liquidity, the managers of these funds can invest in different types of bonds that boost returns.

Current investment conditions are tough to find both resilience and returns. Your year-end review may need to consider alternatives that haven’t been on your radar in the past.

Gary Brooks is a certified financial planner and the president of BHJ Wealth Advisors, a registered investment adviser in Gig Harbor.