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An income investor's survival guide
Even bond king Bill Gross is trimming his sails. But higher interest rates wont crush all bonds. Foreign debt and closed-end funds can make the most of your fixed-income assets.
By Timothy Middleton
Kevin Hartwell, a software program manager in Ashland, Mass., has been migrating a portion of his 10-year-old daughters college fund from equities to fixed income. Thats a prudent step as matriculation nears, but an agonizing one now, when rates are more likely to rise than fall.
My main challenge is how to manage the fixed-income portion of my portfolio so as not to lose a significant portion of the principal, he notes. Hes walking a tightrope because hes drawn toward closed-end municipal bond funds yielding the taxable equivalent of more than 10%, which I recommended in October.
I purchased three of them, he reports, and since then I have enjoyed both the high yield and capital appreciation in the range of 3%. But he knows their yield comes at the expense of interest-rate risk. How, he wonders, will he know when to sell them?
When the Fed aggressively raises short rates, responds Bill Gross, manager of Pimco Total Return Fund (PTTRX), the nation's largest bond mutual fund. I dont expect it for years, he adds, and has put his money where his mouth is, cashing part way out of his own fund to invest in closed-end munis.
Domestic and international opportunities
Municipal bonds, in fact, are the only domestic bonds worth thinking about this year, and foreign bonds look good, too. The very best idea of all is international bond funds, says Jack Malvey, global fixed-income strategist for Lehman Brothers.
Interest rates are higher overseas and softer economies there make rate hikes unlikely. Meanwhile, the dollar is depreciating, adding a kick from currency translations, notably in Europe.
Income investors also can find reliable yields from real estate funds, particularly closed-end funds. They're yielding more than 7% and could appreciate in value enough to deliver total returns in low double digits.
More on income investing in 2004
Time to make a move
This is that strange moment when investors least likely to shake up their portfolios -- fixed-income investors -- would benefit the most from doing it. If you sit on your high-quality domestic Treasury, mortgage and corporate bonds, you could end 2004 with less capital than you have today.
That forecast is based on this assumption: Long-term interest rates will rise this year by at least a full percentage point. The yield on the 10-year Treasury 4.03% on Jan. 16. Gross expects that to increase to 5%. Malvey thinks it will be 5.5%. Splitting the difference, the value of a 10-year Treasury can be expected to fall 10%. Intermediate-term bond funds like Pimco Total Return could fall half as much, erasing their coupons to end the year flat.
Domestic bonds: High-quality bonds had a good year in 2003; Grosss fund delivered a total return of 5.6%. The markets star was junk bonds. Buffalo High-Yield Fund (BUFHX) spurted 20.3%. But manager Kent Gasaway isn't expecting a repeat.
I've invested in single-A bonds (yielding) 6% to 7% virtually my entire career -- 22 years -- and now Im seeing single-B bonds at those yields, he says. Reaching three steps down the quality curve for the same yield is not a formula for making our shareholders money, he says. His fund is 40% cash, awaiting a meltdown.
The stalwart of many fixed-income portfolios, Ginnie Mae funds, had a wretched year. Vanguard GNMA (VFIIX) eked out a 2.49% return, far less than its coupon. Interest-rate risk is expressed as duration, and the duration of mortgage bonds is perverse, automatically extending as rates rise because refinancings dry up.
Half as sensitive
Closed-end municipal bond funds: The muni market is much smaller and less liquid than the taxable market, and therefore it's stickier. Rates move less quickly and less extremely. Malvey says a one-percentage-point increase in rates would lead to a half-point increase for municipals; that is, they're half as rate-sensitive.
Closed-end funds leverage their investments in long-term municipal bonds with borrowings to buy more bonds and boost yields. Those owned by Hartwell, the Massachusetts investor, are yielding more than 7%, which is equal to more than 10% for investors in high tax brackets.
But those lush yields come at a price. One of Hartwells holdings, BlackRock Muni Income Trust II (BLE, news, msgs), has a duration of 18.9%, meaning the principal value of the portfolio would decline 9.5% if muni rates rose one half of a percentage point.
The bond market is expecting the Federal Reserve to nudge rates higher by a quarter percentage point this summer; that expectation is already built into prices. Munis wont take a hit if that happens, but they will if it raises them a half point. Investors in closed-end funds need to watch the rate market carefully.
Another tactic to protect closed-end munis would be to establish a stop-loss order 5% to 10% below their peak value. A technical gambit that can be exploited is a funds 50-day moving average, which can be plotted using MSN Moneys stock charting function.
Another of Hartwells buys, MuniHoldings Fund (MHD, news, msgs), broke below its 50-day moving average in the middle of July, when its price was $14.90. The shares fell as low as $14. The lines crossed again in the middle of September, at roughly $14.55, signaling a buy. It was trading last week around $15.85.
Leverage works
Real estate: In a column last November, I recommended that income investors turn to funds investing in real estate investment trusts. These stock-like creatures are really an income vehicle, yielding between 5% and 10%.
Were projecting 8% to 12% total returns in 2004 from REITs, says Barry Vinocur, editor of the Realty Stock Review newsletter.
You might do better still in closed-end real estate funds, likewise because they're leveraged. Here are a few candidates, compared with two benchmarks, Morningstars average for the real estate fund group, and an exchange-traded index fund:
| Closed-end real estate funds | | Fund | Yield | 2003
Return | Premium/
discount | Expense ratio | | Cohen & Steers Premium Income Realty (RPF, news, msgs) | 7.59 | 51.8 | -4.77 | 0.82% | | Cohen & Steers Quality (RQI, news, msgs) | 7.60 | 50.1 | - 4.24 | 0.87 | | Neuberger Berman Real Estate (NRL, news, msgs) | 7.53 | 47.1 | - 7.24 | 0.85 | | AIM Select Real Estate Income (RRE, news, msgs) | 7.47 | 47.0 | - 7.70 | 0.90 | | Average realty mutual fund | 3.21 | 36.9 | n/a | 1.63 | | iShares Cohen & Steers Realty Majors (ICF, news, msgs) (Index ETF) | 4.99 | 36.7 | - 0.08 | 0.35 |
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Notes: Data as of 1/14/03. n/a=Not applicable. All closed-end funds leveraged. Return is on market price, not net asset value, except for average mutual fund. Mutual fund average yield is 12 month SEC yield.
Sources: ETFConnect.com, Morningstar
Another advantage of closed-end funds is that they have relatively low expenses, since their administrative costs are minimal. In the real estate category, expenses are about half those of open-end mutual funds.
Overseas where the returns are
Foreign bonds: Without question, real rates of return are more attractive outside the United States, says Aran Gordon, global fixed-income analyst for T. Rowe Price. Overnight borrowing rates are 2% in continental Europe and 3.5% in Great Britain. Weaker overseas economics, Gordon adds, produce the likelihood of interest rate reductions.
Also, the dollar is weakening. Funds that do not hedge their currency exposure, such as T. Rowe Price International Bond (RPIBX), will do best. The fund spurted 18.8% last year.
Emerging-markets debt has been the fixed-income leader for years. Pimco Emerging Markets Bond (PEBIX) has delivered double-digit returns in each of the last five years, at an average rate of 22.7%. Its manager, Mohamed El-Erian, expects that to fall to high single or low double digits in 2004, mainly because risk there is less.
Five years ago, 10% of this market was investment grade, he says. Currently over 50% of these countries are triple-B or above.
Even with higher quality, however, yields are lush. This is still an asset class 380 basis points over Treasurys, El-Erian says. Put another way, if one were simply to clip coupons, you would be looking at a return of 8%.
For market timers
Bond-bear fund: Its not quite shooting fish in a barrel, but a bet on higher interest rates could lead directly to ProFunds Rising Rates Opportunity Fund (RRPIX). Using derivatives, the fund aims to deliver 125% of the inverse performance of the 30-year Treasury bond.
The funds duration is 17.85 years, meaning a one-percentage-point jump in long rates should boost this fund 22.3%. So even a half-point jump should deliver double-digit returns. This isnt guaranteed. ProFunds are intended for market timers; they managed to deliver reliable results only on a daily basis.
Over the course of a year, whats called a tracking error can undo those daily results. In 2001, ProFunds UltraShort OTC (USPSX), which should have surged nearly 50% based on its inverse relationship with the Nasdaq 100 Index ($NDX.X), actually declined 8.2%.
Most fixed-income investors can find something appealing among these ideas. They seem riskier than Treasurys on the surface, but its likely that this year, at least some of them aren't.
At the time of publication, Timothy Middleton owned shares in Fremont Bond Fund (FBDFX), which is managed by Bill Gross. He is also writing a book about Gross, "The Bond King," due to be published in February by John Wiley & Sons.
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