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Bond strategies that can still pay off
Rising rates have already done much of their damage. Here are short- and intermediate-term strategies for bond-fund investors.
By Timothy Middleton
Dan Fuss, one of the worlds best bond managers, has two predictions for this year. The first is that the worst of it is over in the bond market. The second: This is the year the Red Sox will win the pennant, he says.
Bostonians, like Chicago Cubs fans, can be forgiven their idle fantasies on the field of dreams. The Red Sox are just behind the Yankees, and lightning can always strike.
But in credit markets, lightning has already struck -- lightning of the destructive rather than the hopeful kind. The average multi-sector bond fund is down 1.1% this year, as of June 7, according to Morningstar. Fusss fund, Loomis Sayles Bond (LSBDX), is down 2.4%.
The question now is, what comes next?
I believe what the Federal Reserve says will happen, which is that interest-rate increases will be "measured" in this economic cycle, ahead of a presidential election and astride a fearful globe. Though Fed Chairman Alan Greenspan vowed last week to remain vigilant against inflation, which could imply a shift to a more aggressive rate strategy, the market shrugged off his remarks; that risk is already built into bond prices.
A strategy for every time horizon
Meanwhile, the market has stampeded far ahead of the Fed at the long end of the rate curve, which the central bank cant control. From its low last year of 3.1%, the rate on the 10-year Treasury has spurted to 4.8%. Fuss and many of his colleagues expect it to top out at 5.25% sometime in the next two years.
If true, that means most of the damage to bonds is over. Not all, but most. So fixed-income investors can plan ahead with considerably more confidence than they had just six months ago.
I recommend two strategies to concerned bond investors, one for the short term (three to 12 months) and another for the intermediate term (one to two years). For the long term, bond investors should remain in excellent diversified funds like Fusss and ride out the rough patches.
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2 choices for short-term investors
Here you have two options, one conservative and one very risky.
The first, for the cautious, is to buy a bank-loan fund. I almost never mention these creatures because they're expensive, their returns are low and virtually all are targeted at brokerage customers. The only true no-load Ive found among them is Fidelity Floating Rate High Income (FFRHX), and its hard to buy: My broker, Schwab, wouldnt accept the ticker symbol. It is, however, available from Fidelity. (Fidelity says the funds also available from TD Waterhouse, and a distribution deal with Schwab is pending.)
Funds such as these own adjustable-rate corporate loans. The borrowers are usually junk-bond rated, so credit risk is high, and so are costs. The Fidelity fund has an expense ratio of 0.86%, about 15% higher than Fusss fund, and its cheap: The average such fund has an expense ratio of 1.45%, as high as an equity fund.
But this year, bank-loan funds have been the best performers, up an average of 1.3% as of June 7, and the Fidelity fund is up 1.4%. Adjustable rates are ratcheting upward, protecting shareholders principal.
The risky option is ProFunds Rising Rates Opportunity Fund (RRPIX). If the yield on the 30-year Treasury bond, currently 5.45%, were to rise to 6.25%, as Fuss expects, this fund should deliver a total return of 14%. This would be a hell of a play on rising rates, says Bill Seale, ProFunds chief investment officer.
Yes and no. The fund, which is 125% leveraged to the inverse of the Treasurys price, performs reliably only on a day-to-day basis. Over the course of a year, the effects of compounding of daily changes are unpredictable.
Imagine you own $100 of any fund designed to match its index perfectly, and that index goes up 10% one day and down 10% the next. How much do you have? Not $100. On day one, the funds value would have shot up to $110. Ten percent of that isn't $10, however, but $11; on Day Two, you have $99.
So even if you're right about the direction of interest rates, if they behave erratically along the road, you cant be sure where youll end up. The odds are youll make money if rates rise, but you wont necessarily pocket a 14% gain.
A moderate approach for the intermediate term
Here the choices fall somewhere between the extremes of risk of the two short-term funds.
The likeliest alternative to a conventional domestic bond portfolio is one of investing in high-grade foreign bonds, particularly those of European governments.
The inflation and growth outlook for Europe is tame relative to the United States, says Sudi Mariappa, manager of Pimco Foreign Bond (PFORX). He notes the European Central Banks sole mandate is to hold down inflation; unlike the Fed, it doesnt act to encourage growth.
All of Europes negatives -- its powerful labor unions, short work weeks, crushing taxes, high unemployment and stagnant markets -- are positives for bonds, which prosper in a bad economic climate. Whats more, Americas biggest negatives -- soaring deficits, including the current-account deficit -- imply a weaker dollar, which could add a currency-translation bonus for Americans who invest abroad.
The domestic alternative to taxable bonds is tax-free bonds. The way I prefer to own them is in the form of closed-end funds, which, unlike mutual funds, can borrow to leverage their returns and supply a higher current yield.
Dreyfus Municipal Income Fund (DMF, news, msgs) was yielding 7.71% as of June 7, which in the top income tax bracket was equal to 11%. Since inception in 1988, its annual total returns have averaged 6.6%.
Manager Joe Darcy was cautious, correctly, about the bond market earlier this year and shortened his portfolios duration, or interest-rate risk, to roughly five years. The funds leverage boosts that measure to about 7.6, meaning a 45-basis-point increase in interest rates could shave 3.4% from net asset value, considerably less than the funds yield.
That's much less than the 9% many such funds have tumbled in recent weeks. I think a lot of the bad news for interest rates is already out there, Darcy says, so his stance has turned to neutral from cautious.
A limited opportunity
Dreyfus Municipal Income is a national fund, designed to appeal to shareholders in states with little or no personal income tax. In high-tax states like my own New Jersey, investors are better off in state-only funds. There are plenty to choose from: A site called ETFConnect.com lists 294 closed-end muni funds.
The peril of a closed-end fund is that its share price -- it trades throughout the day, like a stock -- will fall to a discount to its net asset value, particularly in troubled times. The two New Jersey funds I own have fallen to discounts of about 6.6%. The Dreyfus fund, however, is trading at a slight premium to its NAV.
For credit as well as technical reasons, munis are trading currently to yield more than they have historically. At some point when taxable bonds are more in favor, this premium will disappear. Until then, however, owners of munis are enjoying yields the taxable world isnt likely to see for two years, or maybe more.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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