Government bailouts, particularly from the Federal Reserve, have made high-yield bonds less risky.
Photo: olivier douliery/Agence France-Presse/Getty ImagesProfits are a good thing, but that doesn’t mean it always makes sense to take them.
If you’ve held bonds or bond funds over the past six, 12 or 18 months, you’re looking at a sizable capital gain. For example, Vanguard Total Bond Market ETF (BND) rose 7% in the one-year period through June 30, a hefty move for a bond fund.
So if you’re one of the lucky ones, what do you do with your bond profits? In general, it’s best not to sell in order to collect them, though there are exceptions, financial advisers say.
The main issue is that if you book your capital gain, you will most likely have to take more risk to match the income you are now receiving from your bonds and bond funds. That’s because the lower interest rates that have meant higher prices for your bonds also mean lower yields for the bonds you might buy with the proceeds of your capital gain.
To replicate the income you’re receiving from your current bonds, you would have to opt for bonds with longer maturities and/or a weaker credit profile.
“There’s no such thing as a free lunch in this,” says Dan Goldie, a financial adviser for Buckingham Strategic Wealth in Palo Alto, Calif. “It’s merely the market pricing mechanism working properly.”
Advisers note that the purpose of your bond portfolio should be to provide stability and diversification to offset the risk of your stockholdings, along with an income stream. “I don’t think you should try for high returns with fixed income,” Mr. Goldie says. “Try for that with equities.”
In addition, if you’re selling bonds or bond funds in a taxable account, you’ll have to pay a capital-gains tax. For wealthy people in a high-tax state, that charge is over 30%. So you would have to replace your bonds with ones that have much higher yields or with some other high-return asset to make up for the tax hit.
“I don’t like the arithmetic of that,” says Chris Litchfield, a retired hedge-fund manager who is now a private investor in Greenwich, Conn.
When it makes sense
In some cases, though, it might make sense to take gains, especially in a nontaxable retirement account. One example would be moving to safer bonds—ones with shorter maturities and/or less credit risk, advisers say. “If you have concerns about safety issues, this is an opportunity to de-risk—perhaps from high-yield [junk bonds] to Treasurys,” says Andy Schuler, head of PNC Wealth Management’s investment program.
Some investors might want to move in the opposite direction, taking more risk to pick up some additional yield. If all your bond assets already are in safe bonds, which now have negligible yields, you might contemplate taking profits on some of your holdings and putting them into riskier bonds, some advisers say.
Say you own intermediate- or long-term Treasurys. “If you’re looking to take a little off the table, you can rebalance into investment-grade corporate bonds or municipal bonds if you’re in a high tax bracket,” says Collin Martin, a fixed-income strategist at Charles Schwab. Municipal bonds are tax-free.
If you’re a risk taker, you might even consider dabbling in high-yield bonds, some advisers say. Mr. Litchfield says it’s wise to have a diversified bond portfolio, including Treasurys, municipal bonds, and both high-quality and high-yield corporate bonds. Government bailouts, particularly from the Federal Reserve, have made high-yield bonds less risky, he says.
Switch to stocks?
What about taking your bond profits and venturing into stocks, particularly dividend stocks, which in many cases would provide more income than your bonds?
Advisers recommend against it, unless you’re underweight equities in your asset allocation, which is unlikely given the stock market’s recent run-up. Again, remember that your bondholdings are meant to provide ballast for your portfolio, including an income stream, rather than large returns.
While dividend stocks offer regular income, for the most part they are still riskier than high-quality bonds. “Dividend stocks can be a good way to invest broadly in the stock market, but we don’t like to talk about them in the context of bond investing,” says Schwab’s Mr. Martin.
The ‘preferred’ choice
One investment Schwab favors crosses the border between stocks and bonds: preferred securities. They have characteristics of both asset classes. Like stocks, their dividends are paid after interest on a company’s bonds. But like bonds, preferred securities usually make regular fixed-income payments and have a par value that is returned to investors if the securities mature or are redeemed.
Preferred securities generally have yields close to those of junk bonds but with less risk, Mr. Martin says.
Perhaps you’ve thought of selling your profitable bonds and leaving the money in cash, hoping that interest rates will rise and you can then reinvest the money in bonds with higher yields. Not a good idea, advisers say.
“We never think hope is good,” Mr. Martin says. “The Fed has indicated short-term rates will likely be near zero for 2½ years or more.”
So when it comes to taking profits on your bonds, less generally is more, advisers agree. “Given this environment, if everything you own is a high-quality investment, there probably aren’t moves you need to make, Mr. Martin says.
Mr. Weil is a writer in West Palm Beach, Fla. He can be reached at reports@wsj.com.
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