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Are your bond investments keeping you up at night? If so, there may be good reason.
After more than three decades of gains, the bond rally finally seems to be sputtering. Since the start of 2013, long-term Treasury bond prices have fallen about 2% and quality corporate bonds also are in the red, according to Barclays Capital indexes. One of the only parts of the market posting gains is high-yield bonds — and prices have gotten dangerously high, according to some market analysts, at about 105 cents on the dollar and near the highest level in a decade.
Bondholders could see more volatility ahead too. Many experts think there's a good chance bond market interest rates will tick up this year as investors anticipate higher inflation and stronger economic growth down the road. That means bond prices will fall, since bond yields and prices move in opposite directions. The mere prospect of rising rates has pressured much of the market already, says Jeff Feldman, an adviser with Rochester Financial Services in Pittsford, N.Y.
"If you're going into a bond fund, you need to reduce risk," he says.
Granted, bonds aren't likely to plunge tomorrow. The economy remains sluggish, keeping inflation in check. With payroll taxes increasing and government spending cuts on the horizon, the economy could weaken again. And the bond market could actually rally in coming months as the political fight over the U.S. debt ceiling takes center-stage — sending skittish investors to the safety of government bonds.
Furthermore, the Federal Reserve has signaled it will hold down short-term interest rates until unemployment falls to 6.5% or inflation spikes — neither of which appears likely in the near-term.
Still, it would only take a small increase in rates to wipe out returns in some bond funds, notes Feldman. For example, a fund with a "duration" of five years — a measure of sensitivity to interest rates — would fall about five percentage points if yields were to rise by one point. With the average yield for an intermediate investment-grade bond fund just 2.6%, according to Lipper, investors could quickly see losses if rates were to rise.
While there are more risks in the bond market, most advisers still recommend some exposure to bonds. Treasurys remain a good cushion against losses in stocks, since they typically move in opposite directions. And while yields are generally low across the bond world, corporate bonds can provide a bit more income, especially if you can hold them in a non-taxable account like an IRA. How much to invest in bonds depends on your age and risk tolerance, of course, with most advisers recommending less bond exposure for young investors — say, only 20% for folks in their 20s, up to to 50% for investors close to retirement or already drawing down their portfolio.
Feldman, for one, is putting 40% to 50% of fixed-income assets into "core" funds like DoubleLine Total Return (DLTNX) and PIMCO Total Return (PTTDX), which invest in a wide swath of bonds; and he's pairing that with two moderate, higher-yielding funds, Fidelity High Income (SPHIX) and Loomis Sayles Bond Fund (LSBRX).
Whichever way you go, analysts say it's critical to pick funds that do a good job of protecting capital when rates rise. Funds with a knack for preserving capital often wind up outperforming over time, says Tom Roseen, head of research for Lipper. By losing less when the market goes down, they have less ground to make up on the way back. These funds may not offer the highest yields, but their total returns should eventually make up for their lack of current income, says Roseen.
To find such Steady Eddie funds, we asked Lipper to screen for funds in the top 20% for "consistent returns" over the past three years. These funds have below-average volatility in their category and have generally been steady performers, Roseen says. We also evaluated the funds' sensitivity to interest rates — looking for those with a low duration — and weeded out funds with front-end loads, high minimum investments and high annual fees.
Averaging into these funds over time may be a good strategy to help limit losses if the market is weak, offering better prices later. And of course there's no guarantee these funds will perform well. You should do your own research to see how they fit in your portfolio or consult an adviser before investing.
With a yield of just 1.2%, the Scout Core Plus Bond Fund (SCPYX) may not do much to fatten up your portfolio, but it should fare well in a rising rate climate. Lead manager Mark Egan is investing defensively, holding mainly short-maturity corporate bonds, asset-backed securities and short-term Treasuries to keep the fund in positive territory should rates rise from here — a scenario he thinks looks increasingly likely.
"The best days of bonds are behind them," he says. "It'll be very easy for high-quality bond funds to post negative returns over the next several years. We think it will be quite shocking to people."
A year ago, Egan held larger stakes in long-dated corporate debt, mortgage-backed securities and high-yield "junk" bonds. But he's traded many of the longer-dated securities in the fund for bonds maturing within two to three years, betting they'll hold up better if rates spike. He's also emphasizing asset-backed debt in areas such as auto loans and credit card receivables, figuring they have very low risk of default and less sensitivity to rising rates.
While the fund may be on the conservative side now, it's been a strong performer: Its 9% three-year annualized return beat 91% of peers, according to Morningstar. And it placed in the top 20% of peer funds for consistency, according to Lipper.
With the Fed buying billions in Ginnie Mae mortgage securities every month — propping up prices — investors in this part of the market have fared well. The Barclays U.S. Ginnie Mae Index returned 5.9% over the past three years, and Fidelity Ginnie Mae Fund (FGMNX) beat 90% of peers over that period, according to Morningstar.
Going forward, such strong gains may be tougher to achieve. Ginnie Mae bonds are pools of residential mortgages backed by the federal government, and after years of Fed purchases, the market looks fully valued, says Bill Irving, co-manager of the fund. The Fed may decide to scale back its bond purchases this year, removing a big source of demand from the market. And an increase in interest rates would pressure Ginnie Mae bonds, even though the fund's duration is relatively low at around three years.
Irving thinks rates aren't likely to spike, however. He figures the Fed will be wary of disrupting the mortgage market by making a quick exit, and he sees potential for rates to move lower, sparked by a fight over raising the U.S. debt ceiling. Over the remainder of 2013, the fiscal drag from higher taxes and lower government spending should help support low rates. The mortgage market is also vast and heterogeneous, he points out, consisting of hundreds of thousands of bonds with different characteristics, many of which look attractively priced, creating pockets of opportunity.
Indeed, some Ginnie Maes backed by loans with low outstanding balances look attractive, he says, since they have a lower risk of prepayment and greater potential for gains than the market is anticipating.
Laird Landmann sees Treasury bonds as a death trap these days. With a relatively high duration and low yield, even short- and medium-term Treasurys will lose value fast if rates increase, says the co-manager of Metropolitan West Low Duration Bond Fund (MWLDX). He sees scant reason to hold these bonds, figuring it's only a matter of time before they take a hit.
Instead, he's investing in other areas of the market, from short-term "floating rate" debt to "non-agency" mortgage-backed securities, junk bonds and even debt issued by the Japanese and Mexican governments. The strategy could backfire if there's another financial crisis or the housing market weakens, and Landmann acknowledges "you have to take risk to get return."
But many of the fund's investments should fare well if rates increase, he says. The fund's low duration, combined with a 2.2% yield, give it a two-percentage-point cushion against rates rising, he points out. It's also well-diversified across sectors and different types of debt, he adds, and he's sticking with bonds backed by financially healthy banks and utilities, for example, which have lots of assets and collateral to back up their debt.
No area of the bond market is off-limits to Virtus Multi-Sector Short-Term Bond (PSTCX). This short-term fund holds everything from foreign government bonds to commercial mortgage-backed securities and even a Sony "receivables" deal backed by cash flows from various assets, including the Seinfeld jingle. "These are bonds that offer great value in a short-term fund," says lead manager David Albrycht.
Granted, these types of bonds make the fund unconventional — and potentially riskier than most of its peers, which stick mainly with corporate debt and Treasurys. But staying shackled to plain-vanilla bonds doesn't make sense if better opportunities arise elsewhere, says Albrycht. "We may take on more risk but we're more diversified," he says. "If something makes sense to us on an investment basis, we'll follow it."
In the next 12 months, Albrycht views rising rates as a bigger risk than credit risk, and he's emphasizing areas that could fare well should rates increase. The fund has 15% in "floating-rate" bank loans, for instance, which tend to increase in value as rates rise. Yields on bank loans are now similar to junk bonds, he points out, and the fund's holdings are backed by financially healthy companies.
The fund has had setbacks: It returned a meager 2.9% in 2007, trailing 82% of peers, and lost 14% in 2008 as risky assets sold off indiscriminately. Since then, it's bounced back sharply with a three-year return in the top 2% of general bond funds, according to Morningstar. If you're going to invest, keep in mind that the fund has a $75 transaction fee on the Fidelity platform.
Corporate and U.S. government bonds make up a fraction of Templeton Global Total Return (TTRCX), which makes wide-ranging bets on global currencies, interest rates and foreign government debt — investing in far-flung markets like Malaysia, Korea and Hungary. The strategy may sound dicey, but it has paid off: The fund's 10.4% annualized return over the past three years beat 97% of peers in the international bond category, according to Morningstar.
With about 58% of its assets in foreign currencies, the fund does pose more currency risk than foreign bond funds which stick with U.S. dollar-based debt. And it has made some wrong turns: The fund lost 7.9% in the third quarter of 2011 as a bet against the Japanese yen went awry and positions in foreign bonds declined sharply. The fund lost 1.1% that year, trailing the median return of 3.5% for foreign bond funds, according to Morningstar analyst Miriam Sjoblom.
On the plus side, the fund holds more than 500 positions, diversifying broadly across geographies and sectors. Lead manager Michael Hasenstab — a Ph.D. in economics — is emphasizing countries with relatively low debt levels in Asia and in markets in Europe that don't use the euro such as Scandinavia and eastern Europe. Many countries in these regions offer higher short-term interest rates and have undervalued currencies, he wrote in a recent shareholder commentary. He's also favoring countries whose policymakers are pursuing responsible fiscal and monetary policies, providing support for their bonds.
One other positive aspect of the fund is that its duration is just 2.4 years, largely insulating it from spikes in interest rates, according to Sjoblom. Investors who understand the fund's risks and can be patient should continue to be rewarded, she notes. The fund has a $75 transaction fee on the Fidelity platform.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services. He does not own any of the securities mentioned in this article.
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