Purchase
Tim Middleton's
book
"The Bond King"
at MSN Shopping.
Mutual Funds
Recent articles:
• Build your own hedge fund, 1/24/2006
• Can a 401(k) make up for a lost pension?, 1/17/2006
• Focused funds at bargain prices, 1/10/2006
More...
| | Mutual Funds
Up next: A banner year for bonds
With the Fed just about done raising interest rates, investors who buy bonds can expect a sizeable payoff. How good will it get? For some bond funds, double-digit good.
By Timothy Middleton
Income investors, your torment is over.
For two years, investors who buy bonds -- either as long-term investments or in hope of a steady income stream -- have been bedeviled by low-but-rising interest rates. Its been the worst of all worlds: Low rates drag down yields on savings and money-market funds. Rising rates erode the value of bonds.
This year you will have your revenge. Bond funds are going to go up. The only question is how much.
Short (interest) rates will be lower, as the Fed closes the ongoing tightening cycle at the end of this month and commences an easing cycle by the end of the year, says Paul McCulley, managing director of Pacific Investment Management, in his January commentary to clients.
Lower rates mean higher bond prices. The markets sweet spot will be bonds with maturities of five to seven years.
A new performance leader
Last years fixed-income winners -- ultrashort maturities and bank-loan funds -- are not going to suddenly turn to dust. But they are going to be left in the dust, in terms of performance. Thats because history teaches that years like this one are the best years the bond market has for its stalwarts, those intermediate-term bonds.
Related news and commentary on MSN Money
How good can it be? Double-digit good.
This market pattern has persisted for decades, including the most recent times these circumstances have occurred. In years in which interest rates rise sharply, standard bond funds have done poorly. The following year, however, they have rebounded smartly.
| When rates rise, then stop rising | | Category | 5-year annualized return | 1994 | 1995 | 1999 | 2000 | 2005 | | Bank loan | 4.8% | 6.6% | 7.8% | 5.9% | 5.5% | 4.6% | | Ultrashort bond | 2.7% | 2.0 | 7.8 | 4.4 | 6.6 | 2.5 | | Intermediate-term bond | 5.3% | - 4 | 17.8 | - 1.3 | 9.7 | 1.8 |
|
Note: As of 12/31/2005
Source: Morningstar Inc.
In the 1994 interest-rate cycle, rates were boosted six times, to 5.5% from 3%. In the 1999 cycle, the Fed began tightening in June and boosted rates a total of six times, into the beginning of 2000, to 6.5% from 4.75%.
In the current cycle, the hikes began in June 2004 and have continued ever since. Before todays Fed action, they had been jacked up 13 times, to 4.25% from 1%. The rebound for intermediate-term bond funds began three months ago, as investors began to anticipate an end to this ratcheting up of rates.
As this chart shows, bank-loan funds have been better havens during times of rising rates than the traditional shelter, ultrashort-term bond funds. The former have delivered annualized returns of 4.8% over the last five years, compared with 2.7% for short bond funds.
But almost nobody knows this. Only one true no-load fund invests in this space, Fidelity Floating Rate High Income (FFRHX). Even among broker-sold funds, there are fewer than two dozen of them, and none is nearly as large as Fidelitys, which has $2.52 billion of assets.
The reason, I suspect, is that investors in investment-grade bonds, which is the kind we are talking about, are wary of junk bonds, and thats what high signals in a bond funds name. As the Fidelity funds returns show -- it's up 5% a year over the past three years -- credit quality hasnt detracted from performance.
What everyone should own
But mainstream bond funds are what you want to own now. Even with their recent poor performance, the average one has managed to deliver annualized returns of 5.3% for the last half-decade. And I dont anticipate an average year, so I think the bounce will be well above this level in 2006.
Many 401(k) investors have the option of investing in the Pimco Total Return Institutional (PTTRX), the worlds largest mutual fund and the intermediate-term fund with the best long-term performance. Another choice is iShares Lehman Aggregate Bond (AGG), an exchange-traded index fund I use in my model ETF portfolio.
You can also screen for such funds with our Deluxe Mutual Fund Screener. Here is a screen I created to produce the following table:
| Top bond funds | | Fund Name | 3-year annualized return | 5- year annualized return | Expense ratio | | Metropolitan West Total Return Bond M (MWTRX) | 7.12% | 5.77% | 0.65 | | Westcore Plus Bond (WTIBX) | 6.72 | 6.84 | 0.55 | | American Funds Bond Fund of Amer A (ABNDX) | 6.72 | 6.53 | 0.65 | | Columbia Income Z (SRINX) | 6.42 | 6.96 | 0.72 | | Baird Core Plus Bond Inv (BCOSX) | 5.58 | 6 | 0.55 | | Summit Bond Fund (SABDX) | 5.48 | 5.69 | 0.72 | | Endowments Bond (BENDX) | 5.4 | 6.42 | 0.7 | | Preferred Fixed-Income (PFXIX) | 5.36 | 6.48 | 0.68 | | Franklin Total Return Adv (FBDAX) | 5.29 | 6.24 | 0.55 | | Baird Aggregate Bond Inv (BAGSX) | 4.89 | 6.15 | 0.55 |
|
Notes: As of 12/31/2005. Non-institutional intermediate-term funds. Manager tenure 3 years or more. Expense ratio below 0.75%
Source: Morningstar Inc.
Virtually every investor, except the youngest, should own an intermediate-term bond fund, particularly in the low-return environment we are languishing in now. My model portfolio trounced the stock market last year despite having a quarter of its assets in income-producing funds.
And now is a great time to buy them. Especially if youve been getting an aching back from riding the markets roller coaster in recent weeks, a good bond fund looks like a hammock in the Garden of Eden.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article, although he did own Harbor Bond Fund, which is managed by William H. Gross, manager of Pimco Total Return.
|
