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Bond prices have marched higher in recent years as investors reached for income and safety in a volatile financial world. The broad bond market has returned 6.5% a year during the past five years — trouncing the S&P 500 (.SPX), which lost 7.2% in total. Riskier junk bonds fared even better, returning an average 9.3% annually over that time.
But making money in bonds has gotten much tougher. Yields are now sharply lower across the bond world and prices are high — reducing the odds of strong returns going forward.
That doesn't mean you should sell all your bonds, which are key to diversifying your portfolio and balancing the risks of stocks. But many financial advisers are telling clients to be more opportunistic: to look beyond the traditional government and corporate sectors to areas that offer more of a yield buffer and potential for total returns — without ratcheting up risk.
"There are no magic bullets in bonds these days," says Greg Lavine, a bond trader and financial adviser with Altfest Personal Wealth Management in New York. "Investors have to face reality that they can't just clip coupons and expect to see their principal grow."
Ironically, the riskiest bonds may now be those issued by Uncle Sam. Treasurys have fared well as a safe-haven investment ever since the financial crisis. Yet while there's virtually no risk of the U.S. government defaulting, yields are now so low that "real" returns adjusted for inflation, which is running at about 2% annually, have gone negative for all but the longest-dated 30-year bonds.
Perhaps more troubling, if interest rates rise by just 1 percentage point — a distinct possibility if the economy starts to pick up — most government bonds will fall in price. (Bond prices and yields move in opposite directions.) The 10-year Treasury note, for example, would sink about 9% if rates rise by 1 percentage point — wiping out more than five years of interest income at the note's recent 1.6% yield.
Indeed, investors are now "paying for the privilege of taking interest-rate risk," says Carl Kaufman, lead manager of the Osterweis Strategic Income Fund (OSTIX), who is largely avoiding Treasurys.
Rising Treasury yields pressure other bond prices as well, including corporate bonds. Yields are a bit higher on the corporate side at 2.7%, offering more of a cushion against rising rates than Treasurys. Yet quality corporate bonds aren't paying as much income compared with Treasury bonds as they have in the past. Only a year ago, corporate bonds yielded 2.5 percentage points more than Treasurys, on average; today that spread is down to just 1.3 points. Corporates are also susceptible to rising rates, and would lose an average 6.3% if rates rose 1 percentage point.
Granted, interest rates aren't expected to shoot up tomorrow, and the Federal Reserve has pledged to keep rates low through 2015. Still, the Fed may not be able to hold down rates if expectations for economic growth, and inflation, pick up next year. And even in a slow-growth economy, yields are likely to creep up, hitting 2.33% on the 10-year Treasury by the end of 2013, according to a recent Bloomberg survey of economists.
If you own some bond funds, it's a good idea to check how sensitive they are to rising rates. Funds with a high average "duration" — over seven years, for example — are likely to be hit hardest.
Investors should still hold quality corporate debt and municipal bonds in taxable accounts, says adviser Paul Baumbach, with Mallard Advisors in Newark, Del. But they should also invest opportunistically in areas with higher yields and greater potential for total returns.
"Quality bonds have high prices and low yields," he says. "You still need them in your portfolio in case things go wrong economically, but other areas of the market look more attractive."
To find good options in the fund world, we screened for funds that aren't highly sensitive to rising rates but still offer the potential for strong total returns. Some of our selections have transaction fees on the Fidelity platform, which may increase your costs if you average into them over time. Still, their performance records have been solid. And if the trend continues, their returns should make up for the additional up-front expenses.
PIMCO Income Fund (PONDX) takes an opportunistic, global approach to bonds: The $15.1 billion fund holds nearly half its assets in foreign bonds, including a 21% stake in emerging market debt, and around 40% in non-U.S. government mortgage-backed securities. At other times it has held more Treasurys and junk bonds, and while the mix varies, the strategy has paid off: The fund's 15.7% three-year annualized return beat 98% of peers, according to Morningstar.
One unusual feature of the fund is that it targets a monthly distribution level based on estimates of annualized cash flows from its investments. This typically results in steady income, including a year-end distribution to return any additional cash that may have built up. Indeed, the fund typically pays out a bit less than it earns in investment income, avoiding the need to cut the distribution, and it hiked its distribution slightly in February 2012 to 5.3 cents a share.
Like all PIMCO funds, this one takes its cues from the firm's "top-down" perspective on the global economy and bond markets. The firm's views are somewhat defensive these days, and fund manager Dan Ivascyn is focusing on high-quality companies and income sources, while avoiding businesses tied to swings in economic growth and beleaguered regions such as Europe.
While the fund does take credit risk, its average duration of 3.5 years keeps its interest-rate risk low. Overall, the fund has earned a "solid record," notes Morningstar analyst Eric Jacobson.
Junk bonds offer some of the highest yields on the market, and investors are snapping them up, pouring $34 billion into junk bond funds so far this year, according to Lipper, from $11 billion in 2012, through Oct. 31.
Yet while prices have risen sharply, the bonds still look attractive in today's climate, according to Fred Hoff, manager of the Fidelity High Income Fund (SPHIX), which has returned 12.7% this year.
Many junk bond issuers have strengthened their balance sheets and improved their credit quality by reducing their debt burden in recent years. Default rates of around 2.2% are below the long-term average of 5.6% and show no signs of rising, and with the economy expanding at a modest but steady pace, these bonds should continue do well, Hoff says.
Some analysts argue that junk bond yields are now too low given the risks. But while the market may look pricey, Hoff says it's still possible to find attractively priced bonds with good upside potential.
While most of the fund's assets are considered speculative by the ratings agencies, Hoff focuses on companies that generate stable streams of cash, such as oil- and-gas pipeline operators, health-care providers and telecom companies.
Holding mainly shorter-duration bonds, the fund is less sensitive to rising rates than many other types of bond funds. And Hoff now has about 13% of the fund's money in "floating-rate" bank loans that tend to perform well when rates are climbing.
Rising rates may pose a big risk to most bond funds, but they're likely to boost Oppenheimer Senior Floating Rate Fund (OOSCX), which has returned 6.8% this year. Although the fund's fees are on the high side, and it has a transaction fee on Fidelity's platform, the fund's 10-year returns beat 87% of peers — making it one of the top performers in its category, according to Morningstar.
The fund invests in "senior floating rate" bank loans, a kind of corporate debt similar to a home-equity loan made from a bank. Companies pledge their assets as collateral against these loans, helping protect investors against losses. Yields are similar to those of junk bonds. And interest rates on the loans usually "reset" based on market conditions, making them a good bet in a rising-rate environment.
Bank loans can be risky — they are typically issued by companies rated below investment-grade — and the market tumbled more than 30% in 2008. After a sharp rebound since then, the market is also looking pricey, with most loans trading above 100 cents on the dollar.
Compared to Treasurys, however, these loans don't look so expensive, says fund co-manager Joseph Welsh. Yields are about 5 percentage points above Treasurys, compared to a "spread" of around 2.5 points back in 2006. Defaults rates are low and aren't currently rising. And the fund invests in companies with strong cash flows and well-managed balance sheets.
"Things aren't going gangbusters," says Welsh, "but there isn't a lot of risk in the market."
While many fund managers focus on corporate or government bonds, Carl Kaufman buys whatever he thinks is on sale.
Back in 2002, the lead manager of the Osterweis Strategic Income Fund (OSTIX) put more than 60% of the fund's assets in convertible bonds that had sold off sharply. Many of these companies still had very high levels of cash on their balance sheet, however, and the bonds rebounded. In 2007 and 2008, he added Treasurys which helped limit the fund's losses to 5.5% that year as investors bid up government bonds in a flight to safety.
These trades don't always pan out, of course, and Kaufman's go-anywhere style may not appeal to investors who want a fund that sticks to one area of the market. But the fund has proven itself long-term: It beat the broader bond market in the past 3-, 5- and 10-year periods, according to Morningstar, and has gained 7% this year, keeping it well ahead of the broader bond market's 4% return, based on Barclays U.S. Aggregate Bond Index.
Lately, Kaufman has seen the best deals in junk bonds, putting nearly 70% of the fund's assets in shorter-dated high-yield debt. While that may sound risky, most of those bonds are issued by companies with strong business models that generate plenty of net cash, such as equipment-leasing firms, says Kaufman.
The fund's average duration is 2.4 years, giving it very little interest-rate risk, and 14% of the fund is in bonds maturing within a year — debt that has a low risk of loss and yields 3% to 5%.
One drawback of this fund is that it has a transaction fee on Fidelity's platform, raising costs for investors who want to average in over time. Nonetheless, the fund's annual expense ratio is slightly below the category average, according to Morningstar. And the fund has consistently beaten the market with lower volatility. Says Kaufman, "I want it to be the sleep-at-night fund."
Emerging market debt funds have garnered more than $20 billion in assets this year, and it's no surprise why: Yields are among the highest in the bond world, averaging more than 6%, and many developing markets have stronger growth prospects and less government debt than the developed world — making their bonds more attractive.
TCW Emerging Markets Local Currency Income Fund (TGWIX) buys bonds issued in local currencies in countries such as Brazil and Mexico. That adds currency risk to the fund, which could take a hit if emerging-market currencies sell off against the dollar. Long-term, though, emerging-market currencies are likely to strengthen against the dollar, says David Robbins, co-manager of the fund.
Emerging markets could see their currencies appreciate as their economies grow faster, per capita incomes increase and they attract more foreign investment. Fiscal deficits in developing countries also are lower than they are in Europe and the U.S., he adds. That should lead to stronger emerging-market balance sheets and reduce their need to issue more debt, making their bonds more attractive.
None of this eliminates the fund's currency risk, of course, and since it launched in late 2010 it hasn't been tested during a steep downturn. Still, the fund's 6.3% yield offers a "buffer" against some currency losses. More than 80% of the fund is invested in government-backed debt, and nearly half the fund's assets are in bonds rated investment-grade.
Robbins says he's also focusing on governments likely to allow more flexibility for their currencies to rise, such as Russia and Mexico. Over the long term, if the U.S. keeps running massive deficits, the dollar isn't likely to increase much in value against these currencies, while these countries should fare well.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.
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