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Battered by bonds? Don't run scared
Though more Treasury carnage probably lies ahead, it's not a bad time to own or buy bond funds, especially those that focus on diversified intermediate-term bonds.
By Timothy Middleton
The 20-plus-year bull market in bonds has ended violently, leaving mutual fund investors who thought they had bought safety with losses that are in double digits.
The average taxable bond fund plunged 2.51% in July, seismic by fixed-income standards and the categorys worst one-month decline in 16 years. Funds specializing in Treasury bonds fared far worse, with some plunging nearly 20%.
More carnage could lie ahead. Its not safe to get back in the water, says Tom Atteberry, assistant portfolio manager of FPA New Income (FPNIX), the only bond fund never to suffer a losing year in the last 20. It would not surprise me to see 10-year Treasurys at 5.5% to 6% by the end of 2004. (Editor's note: When this article originally published, Atteberry pegged the rate at 6.5% to 7%. He now say he misspoke.)
That would be a substantial further increase in long-term interest rates from their current level around 4.41%, with bond prices moving the opposite way. But that doesnt mean now is a bad time to own or even buy bond funds. You just need to know which ones.
The shift away from Treasurys, mortgages
In a bear market for bonds, which is what were in, yesterdays rams are todays goats. Treasurys and mortgages will underperform for years. Bonds poised to outperform include those of European and some Third World governments, as well as many corporate issues, including junk. Shorter maturities will be better than longer ones.
Shifts into these securities are already being taken by managers of well-diversified bond funds. Pimco, the nations premier fixed-income investment company, sold mortgage bonds heavily beginning in June, although we could and should have sold more of them, admits Bill Gross, manager of Pimco Total Return Fund (PTTAX), the nations largest bond fund.
We went short-duration relative to our benchmark in early June, says Heidi Hu, head of fixed-income investing for Transamerica Investment Management. That benchmark, the Lehman Aggregate Bond Index, is weighted 35% in mortgage bonds, and Transamerica has slashed its holdings of them.
Ive been warning for more than a year that the bull market in bonds was waning, with government, and especially long government, bonds the most vulnerable. If you have stuck, and continue to stick, with a diversified intermediate-term bond fund, youll do OK.
Im still looking for bond portfolios to have full-year positive returns, says Hu, who urges investors to stay put. My thought, exactly.
Why Treasurys bore the brunt of the sell-off
This spring, Treasury bonds were enveloped in a mini-bubble, says Gross. Investors underestimated the strength of the economy and overestimated the determination of the Federal Reserve to hold rates down.
Rates on the 10-year Treasury note bottomed at 3.11% on June 11. In the days that followed, however, a host of data showed significant economic strength, including lower initial unemployment claims, strong purchasing-manager sentiment and accelerating growth in gross domestic product.
When the Federal Open Market Committee met later in June, it trimmed short rates by a quarter of a percentage point to 1%. The market was hoping for a half-point cut. That and the Feds announcement it was abandoning its fight against inflation to combat its dark-matter twin, deflation, sparked higher mortgage rates. Since most mortgages are passed through directly to investors in the form of bonds from Fannie Mae (FNM, news, msgs), Freddie Mac (FRE, news, msgs) and Ginnie Mae, that huge market began to boil.
Rising mortgage rates automatically extend the effective life of mortgage bonds, because prepayments from refinancings sink. In the Lehman index, the average duration of mortgage bonds tripled to more than three years.
Risk rises in proportion to maturity, prompting sales by managers of diversified-bond funds of those and other bonds to bring it down. Even Fannie, et al, sold long Treasurys because they had to scramble to neutralize the effect of longer maturities in their own portfolios.
Treasury-only funds bore the brunt of the sell-off. American Century Target Maturity 2030 (ACTAX), which invests in zero-coupon Treasurys due to mature in 2030, was Julys biggest bond loser, tumbling 18.2%. Companion portfolios maturing as early as 2020 fell 14% or more. An exchange-traded fund called iShares Lehman 20-plus Treasury Bond Fund (TLT, news, msgs) tumbled 10.7%.
Treasury bonds were the most savaged in the rout because they're immune to all risk except rising interest rates. Bonds that seem riskier, notably corporate junk, were hurt far less.
What managers are buying instead of Treasurys
FPA New Income can claim to have told us so. On June 16, the funds lead manager, Robert Rodriguez, declared a buyers strike against Treasury bonds, comparing their bloated values with those of Internet stocks in 1999 and early 2000.
Rodriguez, who is as superlative managing value stocks as bonds, said the only Treasury bonds his fund would own until the meltdown is over are Treasury Inflation Protected Securities, whose yields rise with the price level.
Atteberry, the assistant portfolio manager, says the FPA funds current portfolio consists of 30% cash, 22% TIPS, 22% junk bonds, 8% very short-term government agency bonds and the balance in other categories, including mortgage pass-throughs.
TIPS are also an important part of Pimcos strategy, owing to their built-in protection against rising inflation. Pimcos Gross also is buying European government bonds denominated in currencies other than the U.S. dollar. The Feds efforts to engineer inflation in the United States will inevitably drag down the greenback, giving non-U.S. investments a currency kick. The Pimco fund also invests in emerging-markets debt.
A place to start
The last time bonds took a beating was in 1999, when long government bond funds tumbled 8.2%, on average. A slightly less violent loss of 7.8% occurred in 1994, in each instance as interest rates rose.
In those same years, however, intermediate-term diversified-bond funds fared far better, declining 1.3% in 1999 and 3.9% in 1994. Over the past 10 years, such intermediate-term funds have delivered 80.4% of the returns on long governments with half the risk, or less.
Heres a basic screen from MSN Money that you can use to begin your search for a top bond fund.
Very long-term investors, which increasingly is almost nobody, can opt to ride out the current storm in Treasurys and mortgages, hopeful they will eventually rebound as they have in the past. The calamitous plunge in Treasury prices abruptly halted at the beginning of August and has not resumed.
I think weve come to the end of the first leg of this bear market, says Gross. We may have a lot more to go, but probably that waits for 2004.
But a bull market in Treasurys and mortgages is years beyond that. Riding the bull makes every investor look smart. When it stops, though, those who remain on board look increasingly foolish.
At the time of publication, Timothy Middleton owned shares of Fremont Bond Fund, which is managed by Bill Gross. He is also writing a book about Gross for John Wiley & Sons.
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