Purchase
Tim Middleton's
new book
"The Bond King"
at MSN Shopping.
Related Articles
A nimble, cheap and safe ETF portfolio
ETF portfolio still trouncing market
Related Sites
Vanguard Group: What rising interest rates can mean for your portfolio
Mutual Funds
Recent articles:
• A safe fund for a hostile market, 8/10/2004
• Patience rewards Hodges Fund investors, 8/3/2004
• Don't buy index impersonators, 7/27/2004
More...
| | Mutual Funds
Dive back into bonds -- the water's fine
Fixed-income investors scared away from bond funds are missing a surprisingly strong performance that looks even better as stocks become riskier. Plus: 5 outstanding bond funds.
By Timothy Middleton
Bond funds have surprised nearly everyone this year, and the surprise is a delight to fixed-income investors. With Labor Day close and sharks once again in movie theaters, at least its safe to go back in the bond market.
Bond funds were supposed to be punished by rising interest rates, but theyre actually doing OK. The average intermediate-term fund this year was up 1.6%, as of Aug. 11, and funds owning long-term Treasurys spurted 3.2%. In the same period, large-cap growth stock funds tumbled 7.1%.
The immediate future looks even better. The economy is weaker than expected, which gives the advantage to bonds over stocks. In addition, federal deficits are smaller than forecast ($450 billion vs. the Office of Management and Budgets $521 billion estimate), easing the supply of new Treasury bonds being issued.
The yield on the 10-year Treasury is probably going to end up around 4.6% at year-end, which is pretty close to where it started, says David Wyss, chief economist of Standard & Poors. That yield is currently about 4.3%, meaning he expects little further erosion in bond prices and a slight uptick in their yields.
Mark Dow, senior fixed-income portfolio manager for Massachusetts Financial Services, predicts that yield will end up between 4.8% and 5% next year, although it could go lower before it begins to rise. The market is in the process of re-rating (economic) growth, and we overshoot on both sides, Dow says.
Overshooting
Earlier this year investors were too optimistic about growth, which in the upside-down world of bonds means their prices went down. Now, well probably get carried away on the downside, he says, meaning the prices could rise, pushing down yields.
Either way, this is comforting to fixed-income investors, many of whom have been frightened away from bond funds because they fear serious erosion of their principal. The last time interest rates went up sharply over a prolonged period, in 1994, intermediate-term bond funds suffered losses that averaged 4%, their worst performance since 1973-74.
But this isnt 1994. One decade later, the Federal Reserve has learned to broadcast its intentions rather than surprise everybody, and a gradual increase in interest rates will actually benefit fixed-income investors, rather than harming them.
The benefits should include sharply higher earnings from money-market funds, as well as higher total returns for intermediate-term funds. These are the type most investors should choose, because historically they have delivered 89% as much as long funds with 40% less risk, according to Morningstar data.
Heres what I expect to happen in the next couple of years. If Im right, fixed-income investors will be rewarded for avoiding stock-market risk.
Take it out from under the mattress
Cash rates: The rates that prevail today -- 1.5% on federal funds, the overnight rate the Fed controls -- are 50-year lows that we're not likely to see again for decades. The Fed has indicated its strategy is to move toward a more normal level for these rates, to which returns of money-market funds are pegged.
Such a level in much of the 1990s was around 3.5% to 4%. After deducting their expenses, money-markets can be expected to offer net returns between 3% and 3.5%. That's a tripling from the current level, meaning investors who hold cash will no longer be penalized for doing so.
Longer rates: The 10-year bond historically has yielded approximately the sum of growth in gross domestic product and the inflation rate. If GDP growth in the next couple of years is in the range of 2.5% and inflation remains around the same level, as it currently is, that implies a yield on Treasurys of around 5%.
Vanguard Group recently published a study it commissioned of the impact of rising rates on bond funds. The study assumed an initial prevailing interest rate of 4%, rising to 6% over two years. It found that funds with an average duration of 5.8 years, or intermediate term, suffered negative real returns for about 18 months, then rebounded to enjoy total annualized returns in the 4% range within four years, more than 5% after about seven years and 6% in 15 years.
This assumes the funds manager took no steps to ameliorate the pain; in the real world, active managers would. The duration of the average intermediate-term bond fund currently is 4.4 years, meaning its value would fall less than the Vanguard example, and thus could deliver positive returns more quickly.
Becoming an activist
The studys conclusion is that inaction is the best reaction to changing rates. I am a bit more activist. I lowered the duration of the fixed-income portion of my model portfolio last November, anticipating a spike in rates that occurred in the first half of this year, and then increased it in June when I felt the worst of the damage had been done.
So I 'm sanguine about bond mutual fund returns at the present time and have increased my exposure in my personal portfolio by switching a portion of assets from Vanguard Total Stock Market Index Fund (VTSMX) to Vanguard Balanced Index (VBINX), which gets 40% of its returns from the bond market.
The above applies if Im right. If Im wrong, especially about the magnitude or pace of rate increases, I will regret not recommending Metropolitan West Strategic Income Fund (MWSTX), which the doubters among you should check out.
Launched just over a year ago, this remarkable fund shot up 13% in the 12 months ended Aug. 11, and thats for a short-term fund whose average peer gained 2.2% in the same period.
Obviously, the fund is doing things quite differently than everybody else. In fact, thats the point. Employing a host of unconventional tactics, the fund is effectively immune to movements in both stock and bond markets.
Correlation to the market
The funds R-squared, or sensitivity to market indexes, is minus 1% compared with either the Merrill Lynch 1 to 3 Year Treasury Index (short) or the Lehman Brothers Aggregate Bond Index (intermediate), and that's effectively zero. It is plus 1% compared with the S&P 500 index, but on a scale where 100% shows complete correlation, that's also nil.
The $160 million fund makes big bets on interest rates. Negative bets accounted for the lions share of first-year performance. It also makes big bets on market sectors, such as its current 38% weighting in asset-backed securities, compared with their weight of less than 2% in the Lehman Aggregate.
And it uses a variety of derivatives, such as interest-only mortgage strips and credit default swaps, to buttress returns and hedge against risk. But the funds short track record means I cant have any confidence it can be successful over long periods. This year, as of Aug. 11, its ahead only 2.8%, and Metropolitan Wests other bond funds, in Morningstar ratings, generally display above-average risk for average returns.
It also has an extraordinarily high expense ratio, of 2.35%, which varies with performance. The average for a bond fund is around 1%, and you can get a great one, Harbor Bond (HABDX), for 0.58%.
Other outstanding bond funds include Pimco Total Return Institutional (PTTRX) (a 0.43% expense ratio), available in many 401(k) plans; Dodge & Cox Income (DODIX) (0.45%) and Legg Mason Investment Grade (LMIGX) (1%).
So I cant recommend the Metropolitan West fund (but concede in advance I could be making a mistake). I think conventional bond funds are attractive enough to make surrogates unnecessary.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Vanguard Balanced Index. Harbor Bond Fund and Pimco Total Return are managed by William H. Gross, about whom Middleton wrote a book, "The Bond King," published in March.
|
