Bonds - Why do we own them?

Bonds are worth owning. Yes, the credit markets are a mess and bonds did fall in value during the Second Quarter 2008 but bonds offer stability. Bonds are much less volatile then commodities, stocks and residential real estate. See the adjacent chart. Bonds have a standard deviation of only 1.1% while oil's is over 9%. Standard deviation measures how scattered the returns are from the average. The more variation the higher the standard deviation. The down side is bonds earn less than stocks. So even though stocks are more risky in the long run they generate a higher return.

I view bonds as an insurance policy. How much long term return do you want to give up to gain stability? You are essentially buying an insurance policy for your portfolio the way you would for your home. In the case of property insurance, the question is how much current income are you willing to spend to protect you home from a catastrophic event. You are never going to make as much money invested in bonds instead of stocks. So how much do you need to invest in bonds to protect your portfolio from a catastrophic event? That depends on whether you need the money now or are years away from retirement. It depends on how well you can handle short term market swings. It depends on how much money you have and how much money you'll need and when. So the answer is it depends on your needs and your money personality. In other words, there is no magic formula. So it is important to carefully address all these issues when determining your allocation to bonds.

Bank Loan Investment Funds

Two years ago I started investing in bank loan mutual funds for many of our clients. They are a great way to diversify a portfolio without giving up bond income. Last year our bank loan investments earned approximately 9% versus the Lehman Bros Aggregate ishares which earned only 4%. Not bad for a bond fund that is senior secured debt and regularly resets for interest rate changes.

Senior floating rate loans are loans made by U.S. Banks and other financial institutions to large corporations. Floating rate funds are less susceptible to interest rate risk than fixed rate bonds because rates are periodically reset to the prevailing interest rate. So if interest rates increase slowly this fund is less apt to generate a negative return. These loans are the senior source of capital in a borrower’s capital structure (they are first in line if the company goes bankrupt) and have some of the borrower’s assets (real estate, machinery, investments) pledged as collateral.
So if the borrower defaults on the loan the assets become the property of the mutual fund. The value of the collateral may not offset the full value of the loan but the Eaton Vance fund has tried to minimize the risk of default by monitoring creditworthiness of the borrowers carefully and spreading risk by investing the fund in over 450 separate loans. Rarely does a loan represent more than 1% of the fund’s assets. This broad diversification helps to minimize the impact of default.

Year-to-date the Instituional shares are up 2% versus the Lehman Bros Aggregate ishare ETF (AGG) which are up 1.7%.

Attached is a write up by Eaton Vance regarding bank loans.

http://www.eatonvance.com/alexandria/2096.pdf

The Financial Pragmatist
Libby Mihalka