By RANDALL W. FORSYTH
Treasuries suddenly are popular at new-low yields. Return of capital trumps return on capital.
GROUCHO MARX FAMOUSLY SAID he wouldn't want to be a member of any club that would have him. Based on that principle, when the crowd starts saying positive things about Treasuries, I get worried.
I should first confess that I've been working from home for the better part of the past couple of weeks, which has meant I've been watching more financial television than usual. That, I suspect, may be warping my perceptions.
In any case, I was taken aback by some comments on the tube about the attractiveness of U.S. Treasury securities after the yield on the benchmark 10-year note fell below 3%. Understand that Treasuries had been the object of universal derision among the investment cogniscenti, sort of the equivalent of minivans among auto enthusiasts.
Yet somehow these minivans have been lapping the hottest sports cars. In round terms, the iShares Barclays 20+ Year Treasury Bond exchange-traded fund (TLT), is up more than 10% since April while the PowerShares QQQ ETF (QQQQ) that tracks the Nasdaq 100 is down more than 10%. Call it revenge of the nerds.
This hasn't been a short-term phenomenon. As Robert Kessler, head of the eponymously named Kessler Investment Advisors of Denver, points out, "perpetually maligned" 10-year Treasury zero-coupon STRIPS have outperformed both stocks (using the Standard & Poor's 500) and commodities (as measured by the GSCI total return index) over the past three, five, 10, 15 and 20 years.
Bull markets in bonds, Kessler continues, last as long as 37 years. Yields peaked some 28 years ago in 1982, so they can continue to decline. Even at this relatively advanced stage of the Treasury bull market, he also points out that U.S. households' allocations to Treasuries is just 1.7%, compared to 4.6% in 1994 and 8.1% in 1952. That doesn't take into account proxies such as ETFs such as TLT, but the underweighting of Treasuries makes suggestion of a bubble less than credible.
Most active investors have missed the rally that has brought the yield on the Treasury 30-year long bond down from 5% before Easter to under 4% ahead of the July 4th holiday. What's even less well understood is the implications of the bond math of that advance. It's a bigger percentage move than what's remembered as the greatest bond rally in history, when yields fell from 14% to under 10% in the early 1980s. In price terms, the recent gain has been over 20% on long-term STRIPS -- during a period that deep thinkers about concepts such as black swans asserted that everybody should short Treasuries.
But now that the two-year note yield dropped to a record low under 0.6% -- even below the crisis lows following Lehman's collapse in late 2008 -- or the three-year note is under 1% or the five-year note is under 2%, the wisdom of owning Treasuries is being appreciated even by talking heads on cable TV.
Which is what makes me uncomfortable. Intel (INTC) yields 3.10%, more than the 10-year Treasury and is arguably the most important tech company in the world. If there were no Apple, life would go on without its lovely gadgets. Without Intel microprocessors, personal computers -- including Macs -- couldn't function.
Microsoft (MSFT) yields more than the five-year Treasury at 2.1o%. And most of Corporate America uses Windows and Office, the programs that produce massive free cash flow to Microsoft investors.
So, the question is why own Treasuries when Blue Chips such as Intel and Microsoft yield more? Simply because those stocks lost 3% and 4%, respectively, in Tuesday's rout. Other Dow stocks such as ExxonMobil (MOB) and Altria (MO) also lost 2% even though they handily outyield Treasuries.
Market psychology is being dominated by another dictum of one of Groucho's contemporaries, Will Rogers. The homespun philosopher said in the 1930s that return of capital was more important than return on capital.
This is more than a quarter-end phenomenon, although the calendar clearly is exaggerating the market's swings. The decline in all risk assets, notably commodities along with equities, points to economic weakness and, perhaps, outright contraction. That would suggest lower stock prices and Treasury yields in the near term.
Over the next 10 years, I would rather own stocks of great American multinational companies that create wealth rather than the debt of the U.S. government, which absorbs wealth. Over the next 10 months, I'm not so sure. And on that score, I'm afraid I have too much company. Even so, I'd rather protect principal for now in order to have the cash to buy these great companies later at bargain prices.
From online Barrons published on WEDNESDAY, JUNE 30, 2010
Bonds Gain in Best Year Since ‘05 as Rally May End
June 28, 2010, 6:14 AM EDT
(Updated today’s 10-year yield in sixth paragraph.)
By Mary Childs
June 28 (Bloomberg) -- Global bond returns may have nowhere to go but down after the best first half since 2005.
Investors who piled into Treasuries, bunds, gilts, and Japanese bonds on concern that Europe’s sovereign-debt crisis would derail global growth are finding the securities less appealing with yields at about the lowest on record. The emerging bearishness may be most apparent in the $4.3 trillion- a-day market for U.S. Treasury repurchase agreements, where no maturity commands a premium.
That’s a switch from a year earlier, when investors resorted to paying interest to borrowers while lending cash just to obtain Treasuries after the worst finance crisis since the Great Depression. None of the securities are what traders call on “special” in a sign that investors don’t expect Europe’s sovereign debt crisis will curb the global economic recovery, according to data from GovPX Inc., a unit of ICAP Plc, the world’s largest inter-dealer broker.
Choosing the Right Bond Funds
Determine Your Bond Fund Allocation
Before you choose bond funds, it is important to decide the role they will play in your portfolio. Your bond fund allocation should reflect your investment time horizon; your specific investment goals, which may include retirement, retirement income, or tax-free income; and your tolerance for risk.
chart This chart can help you determine an appropriate allocation for bond funds while recommending allocation levels for investment-grade, high-yield, and international bonds to help you meet the needs of your individual investment time line.
Use our tool to see what we suggest for your portfolio
Investing in several bond funds with different investment strategies can help cushion the effects of interest rate risk and credit risk on your overall portfolio. For example, investing in both shorter- and longer-term maturities can help your strategy stay on track during both high and low interest rate climates. This also can be achieved by investing in a diversified single-fund option like the Spectrum Income Fund.
U.S. Treasury Bond Funds
These funds invest in Treasury-bills, Treasury notes, and Treasury bonds issued by the federal government, with varying maturities:
* Treasury bills or "T-bills" have maturities of 13 weeks, 26 weeks, or one year
* Treasury notes mature in two to 10 years
* Treasury bonds mature in 10 years or longer
They are high-quality, relatively safe investments with almost no risk of default. Treasury securities are backed by the full faith and credit of the U.S. government. Although the securities in which the funds invest are backed by the U.S. government, the funds themselves are not. Yield and share price will vary. Bond funds of this type are also subject to interest rate risk, the degree of which depends on the maturity. (Longer-term bonds have a higher risk/return potential.)
Who should invest? Investors with a low risk tolerance or those who seek to balance a higher-risk portfolio with securities backed by the credit of the government.
Tax-Free Bond Funds
Municipal bond funds offer income that is exempt from federal taxes. In addition, certain state-specific municipal bond funds can provide income free of state and local taxes to state residents. Tax-free bonds typically offer lower yields than comparable bond funds, but in many cases this is more than offset by tax savings, resulting in higher after-tax income.
(Some income may be subject to the federal alternative minimum tax.)
Who should invest? Investors in a higher tax bracket or those who live in high-tax states should consider tax-free bond funds.
Corporate Bond Funds
These funds invest in bonds issued by corporations. The funds' risk/return potential can vary according to term length and credit rating. Some corporate bond funds invest in bonds that are below investment grade and pose higher risk but offer higher return potential than other funds concentrating on investment-grade corporate bonds.
Who should invest? Investors who can withstand more price fluctuations with the prospect of higher returns compared with U.S. Treasury funds. Depending on the fund’s risk/return potential, corporate bond funds can be appropriate for any portfolio.
Mortgage-Backed Securities Funds
These funds invest primarily in certificates, such as those issued by the Government National Mortgage Association (GNMA, or Ginnie Mae), that represent a pool of mortgages. They also may invest in securities issued by other government-sponsored enterprises. Mortgage-backed securities tend to have high credit quality; in fact, GNMA guarantees the timely payment of interest and principal on its securities, a guarantee backed by the U.S. Treasury. However, mortgage-backed securities also carry market, credit, maturity, and prepayment risks.
Who should invest? Investors seeking higher income than is provided by Treasury securities of comparable maturity and who can tolerate greater risk should consider mortgage-backed securities funds.
International and Global Bond Funds
Investors can use international or global bonds to diversify their bond allocation in their overall portfolio. International bond funds invest in bonds issued by countries or corporations outside the U.S., while global funds may also include U.S. issuers. These funds are subject to special risks that are typical of international investing such as currency fluctuations and political and economic changes. Bond investments from emerging markets are particularly volatile.
Who should invest? Investors seeking further diversification opportunities and higher potential returns should consider the advantages of global and international bond funds.
Blended Bond Funds
Investors who do not wish to pick and choose a selection of bond funds can invest in a diverse range of bond funds with one selection, as in the Spectrum Income Fund. Single-fund options may combine short- and long-term bonds, domestic and foreign bonds, and different credit ratings to maximize potential earnings while addressing risk.
Who should invest? Investors who want convenience and broad exposure across the spectrum of bond fund options should consider a single-fund solution.
From T.Rowe Price
Mortgage Bond Prices Rise to ‘Insane’ Records: Credit Markets
By Jody Shenn
June 24 (Bloomberg) -- Mortgage securities with U.S.-backed guarantees are trading at record high prices on speculation homeowner refinancing will fail to accelerate and as supply of the bonds remains limited.
The average price of $5.2 trillion of bonds guaranteed by government-supported Fannie Mae and Freddie Mac or federal agency Ginnie Mae climbed to 106.3 cents on the dollar yesterday, according to Bank of America Merrill Lynch’s Mortgage Master Index. That’s up from 104.2 cents on March 31, when the Federal Reserve ended its program purchasing $1.25 trillion of the debt.
“It’s gotten insane,” said Scott Simon, the head of mortgage-backed securities at Newport Beach, California-based Pacific Investment Management Co., manager of the world’s biggest bond fund. “This is rarefied air.”
U.S. existing home sales unexpectedly fell last month and purchases of new houses tumbled to a record low, underscoring how borrowers’ ability to qualify for financing is limited even as rates drop. Bond prices show investors aren’t concerned homeowners will pay back the mortgages underlying the securities at a faster pace, handing them their money back at par and forcing them to reinvest in new debt at lower yields.
Applications for mortgage refinancings are off almost 57 percent from last year’s peak reached in January, according to the Mortgage Bankers Association. The average rate on a typical 30-year home loan fell to a record low of 4.69 percent in the week ended today, down from this year’s high of 5.21 percent in April, McLean, Virginia-based Freddie Mac said today.
Refinancings Suppressed
Refinancings are being suppressed because more than 23 percent of homeowners with mortgages owe more than their houses are worth, according to Seattle-based Zillow.com. Borrowers also face tougher underwriting standards at lenders selling debt to Fannie Mae and Freddie Mac, said Tad Rivelle, head of fixed- income investments at Los Angeles-based TCW Group Inc., with $115 billion in assets under management.
Elsewhere in credit markets, the extra yield investors demand to hold corporate bonds instead of government debt was unchanged at 194 basis points, or 1.94 percentage point, the Bank of America Merrill Lynch Global Broad Market Corporate Index shows. Yields averaged 4.002 percent.
Indicators of corporate bond risk in the U.S. and Europe rose. The Markit CDX North America Investment Grade Index of credit-default swaps, which investors use to hedge against losses on corporate debt or speculate on creditworthiness, climbed 3.65 basis points to a mid-price of 119.15 basis points as of 11:44 a.m. in New York, according to Markit Group Ltd. In London, the Markit iTraxx Europe Index of swaps on 125 companies with investment-grade ratings increased 4.95 to 129.75, Markit prices show.
Bondholder Protection
The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
Yields on Washington-based Fannie Mae’s current-coupon mortgage bonds backed by 30-year fixed-rate home loans fell to about 3.85 percent yesterday, the lowest since January 2009, before rising to 3.86 percent as of 11:55 a.m. today in New York, according to data compiled by Bloomberg.
Their yields have fallen to within 76 basis points of 10- year Treasuries from this year’s high of 93 basis points on May 24, after climbing from a record low of 59 reached March 29.
Yesterday, Fed officials retained a pledge to keep the benchmark interest rate at a record low for an “extended period” and signaled that Europe’s debt crisis may harm American growth.
‘Extended Period’
The central bank, at a two-day meeting, left the overnight interbank lending rate target unchanged in a range of zero to 0.25 percent, where it’s been since December 2008. High unemployment, low inflation and stable price expectations “are likely to warrant exceptionally low levels of the federal funds rate for an extended period,” the Fed said, repeating language from every policy meeting since March 2009.
Bond buyers view so-called agency mortgage securities as a refuge, said Andrew Harding, who oversees $22 billion as the chief investment officer for taxable fixed-income at PNC Capital Advisors LLC in Cleveland. The government is promising to help Fannie Mae and Freddie Mac honor their guarantees.
“They’ve become an anchor in portfolios,” Harding said. “It’s not Treasuries. It’s got some yield, but it’s not equity- like risk.”
The market for agency mortgage bonds has shrunk since it peaked at $5.4 trillion in February, partly because Fannie Mae and Freddie Mac decided earlier this year to purchase about $200 billion of delinquent loans out of their securities to reduce their expenses, according to Bank of America data.
Fed Purchases
Many outstanding securities are also no longer trading after the Fed’s unprecedented purchases, which began in January 2009, and the Treasury’s acquisition of an additional $220 billion of the debt in a separate program begun after the U.S. seized Fannie Mae and Freddie Mac in September 2008.
The weak housing market will likely limit future issuance, said David Land, a mortgage-bond manager at St. Paul, Minnesota- based Advantus Capital Management Inc., which oversees about $18 billion. Outstanding U.S. home-mortgage debt has dropped in eight straight quarters since the third quarter of 2008, falling 3.6 percent to $10.2 billion, Fed data show.
New-home sales tumbled 33 percent last month to a record low annual pace of 300,000, the Commerce Department said in a report. Sales of previously owned homes unexpectedly fell 2.2 percent in May, the National Association of Realtors said.
Home Prices Fall
The median U.S. home sales price slid 29 percent to an almost eight-year low of $164,600 in February from a peak of $230,300 in July 2006, according to the National Association of Realtors in Chicago.
Refinancing hasn’t climbed much partly because there are fewer loan brokers competing to earn fees after being blamed for creating more bad loans than direct lenders, Land said.
“There’s less of a solicitation effort going on,” he said. “If anybody were to figure out a way to refinance people, the mortgage-bond market would be in really bad shape.”
Only about 37 percent of 30-year loans are “actually refinanceable” at current mortgage rates, about half of the level suggested by “traditional measures,” Credit Suisse Group AG analysts led by Mahesh Swaminathan wrote in a report. Rates would need to decline to about 4.5 percent for refinangings to begin to jump, the analysts and BNP Paribas’ Anish Lohokare wrote today.
Pimco Cuts Holdings
Pimco’s $228 billion Total Return Fund reduced its holdings of mortgage securities to 16 percent last month, down from 83 percent in January 2009, according to disclosures on its website. Even after ending, the Fed’s purchases are helping fuel an imbalance between supply and demand, Simon said.
The mismatch has contributed to a jump in unsettled mortgage-bond trades, which remain elevated after soaring to the highest on record last month according to Fed data, and a related drop in the cost of borrowing to invest in certain home- loan securities in the so-called dollar roll market.
With dollar rolls, an investor seeking to borrow money enters into contracts to sell mortgage securities one month and then buy similar bonds the next month; a lender would undertake the opposite trades.
The implied cost of such financing for Fannie Mae’s 5.5 percent securities, backed by higher-rate loans than the current-coupon bonds that guide mortgage rates, was about negative 1 percent yesterday, according to Barclays Plc’s estimates. That means debt investors are essentially being paid to borrow rather than paying their lenders.
Prices for some securities have “benefited substantially” from such “roll specialness,” Nicholas Strand, an analyst in New York at Barclays, wrote in a June 18 report. The Fed may “look into helping to facilitate market liquidity” through temporary sales into the roll market, hurting values, he said.
--With assistance from John Detrixhe, Sarah Mulholland, Gabrielle Coppola and Emre Peker in New York, Kathleen M. Howley in Boston, Drew Benson in Buenos Aires, Ed Johnson in Sydney and Jungmin Hong in Seoul. Editors: Alan Goldstein, Michael Weiss
To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net
To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net
From Bloomberg BusinessWeek Published on June 24, 2010, 12:08 PM EDT
Junk Bonds Reviving on Bernanke’s ’Subpar’ Economy
June 22, 2010, 10:44 PM EDT
(Corrects CNH Global’s bond coupon in 21st paragraph.)
By Pierre Paulden and Tim Catts
June 23 (Bloomberg) -- Investors are returning to junk bonds after the worst month since 2008 on speculation the economy is growing fast enough to avert corporate defaults without sparking inflation.
“High yield is the place to be,” said Manny Labrinos, a money manager at Nuveen Investment Management who helps oversee $78.4 billion of fixed-income assets. “Subpar growth is somewhat of a Goldilocks scenario because it means rates stay low and people are still going to reach for yield.”
High-risk debt has returned 1.76 percent in June, almost double the gain of investment-grade corporate bonds, Bank of America Merrill Lynch index data show. Underscoring demand, CNH Global NV, the Fiat SpA unit that makes tractors and harvesters, boosted the size of its speculative-grade offering by 50 percent to $1.5 billion in the largest junk-bond sale since April 20.
The rally is eroding a 3.52 percent loss in May as credit- ratings companies upgrade borrowers at the fastest pace since at least 2000 amid rising corporate profits. Economists expect Federal Reserve policy makers led by Chairman Ben S. Bernanke to keep interest rates at record lows as U.S. unemployment holds near a 26-year high.
Moody’s Investors Service upgraded 86 high-yield companies and downgraded 48 in the quarter, a ratio of 1.79 times, Bloomberg data show.
Great Recession ‘Survivors’
“Default rates will be well below most people’s estimates at the beginning of the year,” said Mark Durbiano, head of high yield at Federated Investors Inc., where he oversees $4 billion of speculative-grade debt. “The market is pretty much made up of what I call survivors of the Great Recession, where you defaulted out a lot of the weaker issuers and new issuers are creditworthy.”
Elsewhere in credit markets, the extra yield investors demand to own company bonds instead of government debt was unchanged at 194 basis points, or 1.94 percentage point, the Bank of America Merrill Lynch Global Broad Market Corporate Index shows. Yields averaged 4.027 percent.
Yields on Fannie Mae and Freddie Mac mortgage securities that guide U.S. home-loan rates fell to the lowest in more than a year. On Fannie Mae’s current-coupon 30-year fixed-rate mortgage bonds, or those trading closest to face value, it dropped to about 3.87 percent, within 66 basis points of 10-year Treasuries. That’s the least since April 16. Spreads widened to about 70 basis points in late trading as of 5 p.m. in New York, according to data compiled by Bloomberg.
‘Prepayment Risk’
“In a world where investors can take on various risks such as sovereign risk, credit risk, liquidity risk and prepayment risk, prepayment risk seems the least distasteful at the moment,” JPMorgan Chase & Co. analysts led by Matthew Jozoff in New York wrote in a June 18 report.
Investors in agency mortgage bonds may be paid back faster than they expect if home-owners refinance or move, and slower if financing costs rise. That adds risk as they may need to make new investments at a time when yields are unfavorable. Spreads on the securities are dropping toward record lows set when the Fed was buying the debt.
Vodafone Group Plc, the world’s largest mobile-phone company, is talking with lenders to raise at least $4 billion to refinance debt. The company, based in Newbury, England, plans to get a five-year credit line to replace a three-year deal signed in 2008, said three people familiar with the situation who declined to be identified because the talks are private.
Vodafone spokesman Simon Gordon declined to comment.
Hurricane Season
The cost to protect BP Plc’s bonds against default climbed as the first storm of the Atlantic hurricane season threatens to disrupt efforts to clean up the worst oil spill in U.S. history.
Credit-default swaps tied to London-based BP surged 61 basis points to 538.9 basis points, according to CMA DataVision prices. The storm may enter the Gulf of Mexico as soon as next week, a Planalytics Inc. meteorologist said. Forecasters including AccuWeather Inc. are predicting the season may be among the worst on record.
A benchmark credit-default swaps index for North America rose for the first day in almost two weeks. The Markit CDX North America Investment Grade Index of credit-default swaps, which investors use to hedge against losses on corporate debt or speculate on creditworthiness, climbed 7.3 basis points to a mid-price of 115 basis points as of 6:23 p.m. in New York, the first increase since June 9, according to Markit Group Ltd.
In London, the Markit iTraxx Europe Index of swaps on 125 companies with investment-grade ratings increased 5.5 to 118.1, Markit prices show.
Investor Confidence
The indexes typically rise as investor confidence deteriorates and fall as it improves. The swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
In emerging markets, the extra yield investors demand to own company bonds relative to government debt rose 11 basis points to 315 basis points, the biggest increase since June 4, according to JPMorgan’s Emerging Market Bond index.
Argentine bonds declined, snapping a nine-day streak of gains, as the government’s offer to restructure $18.3 billion in defaulted debt expired. The yield on the country’s 7 percent bonds due in 2015 rose 57 basis points to 13 percent as of 5:30 p.m. in New York. The price slid 1.82 cents to 79.17 cents on the dollar.
High-Yield Sales
Issuance of speculative-grade debt, ranked below Baa3 by Moody’s and lower than BBB- at Standard & Poor’s, is reviving after Spain sold bonds last week and equity analysts boosted second-quarter estimates for companies in the S&P 500 Index to $19.72 per share from $19.11, according to JPMorgan.
CNH Global’s 7.875 percent notes maturing in December 2017 priced to yield 536 basis points more than similar-maturity Treasuries, Bloomberg data show. The offering from the Amsterdam-based unit of Italian automaker Fiat that makes Case and New Holland agricultural equipment adds to $4.3 billion of high-yield bonds sold this month, Bloomberg data show.
The sale was the biggest U.S. high-yield issue since CF Industries Holdings Inc., the Deerfield, Illinois-based fertilizer maker acquiring Terra Industries Inc., sold $1.6 billion of 8- and 10-year notes on April 20, according to Bloomberg data.
Junk bond sales declined 80 percent last month to $6.76 billion from $33.4 billion in April as European banks’ funding costs soared and investors sought the safety of U.S. government debt.
Speculative-Grade Inflows
Investors put $164 million into high-yield bond funds in the week ended June 16 after withdrawing $6.27 billion in the five previous periods, according to EPFR Global, a Cambridge, Massachusetts-based research firm that tracks asset allocations.
Last month’s decline in junk bond returns was the worst since an 8.4 percent drop in November 2008, according to Bank of America Merrill Lynch’s U.S. High Yield Master II index. Investment-grade bonds have returned 0.98 percent in June, following a loss of 0.57 percent last month.
“Sentiment has definitely improved from a very low base at the beginning of the month,” said James Lee, a fixed-income analyst at Calvert Asset Management in Bethesda, Maryland, which has $7.6 billion of fixed-income assets under management. “The high-yield market is recovering and investors have money to put to work and they are looking for new deals to do it.”
Fed Meeting
All 97 economists surveyed by Bloomberg forecast Fed policy makers will keep their target rate for overnight loans between banks at a record low range of zero to 0.25 percent following a two-day meeting that ends today. The hazard posed by the European debt crisis, joblessness and a lack of inflation add to the reasons why central bankers will focus on sustaining the economic rebound.
Governments across the 16-nation euro region are cutting spending after Greece’s near default sparked investor concern that budget deficits are spiraling out of control. While tighter fiscal policy may slow economic growth, the crisis has also pushed the euro down 13 percent against the dollar this year, boosting some European exports.
The difference in yield between five-year Treasuries and Treasury Inflation Protected Securities indicates investors anticipate an inflation rate of 1.69 percent in the next five years, compared with 2.01 percent on April 28, when policy makers concluded their last meeting on monetary policy.
Corporate spreads should decrease based on the rate that companies are defaulting on debt, said Martin Fridson, a global credit strategist at BNP Paribas Asset Management in New York.
The trailing three-month default rate of 2.95 percent on May 31 signals that the spread on high-yield debt should be 485 basis points, Fridson said, citing BNP and Merrill Lynch index data going back to 1996. Relative yields over government debt have declined 23 basis points this month to 675 basis points, Bank of America Merrill Lynch index data show.
“I think we can say with confidence that the spread is too wide relative to the prevailing default rate,” Fridson said. “I attribute that fact to the anxiety about sovereign risk. More is coming out suggesting that the banks will be covered and those concerns are somewhat overstated.”
--With assistance from Jody Shenn, Craig Trudell, Shannon D. Harrington and Sapna Maheshwari in New York, Patricia Kuo and Kate Haywood in London, Timothy R. Homan in Washington, Drew Benson in Buenos Aires, Esteban Duarte in Madrid and Ed Johnson in Sydney. Editors: Alan Goldstein, Richard Bedard
To contact the reporters on this story: Pierre Paulden in New York at ppaulden@bloomberg.net; Tim Catts in New York at tcatts1@bloomberg.net
To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net
From Bloomberg Business Week published on June 22, 2010, 10:44 PM EDT
Asia Company Bond Spread Gap Shows Battered Junk Debt to Rally
June 20, 2010, 7:48 PM EDT
By Shelley Smith
June 21 (Bloomberg) -- The gap between spreads on Asia’s lowest investment-grade bonds and its top high-yield notes widened to the most in a year, signaling junk debt may rally after investors dumped it amid Europe’s fiscal crisis.
The difference between bonds ranked at least Baa3 by Moody’s Investors Service or BBB- by Standard & Poor’s and those one grade lower at Ba1 or BB+ climbed to 2.8 percentage points after rising to as much as 3.15 percentage points last month, Bank of America Merrill Lynch data show. That’s almost five times the 0.61 percentage point gap of June 2009 and 1.1 percentage points above the one-year average.
“If you can take a long-term view the high-yield space looks pretty attractive,” Gregor Carle, Fidelity International Ltd.’s fixed-income investment director, said in an interview in Hong Kong. “Without a doubt there are opportunities to be found in the gap between investment-grade and high-yield.”
Concern about contagion from Greece’s fiscal crisis triggered five weeks of withdrawals from global speculative- grade bond funds through June 9, according to EPFR Global, even as Moody’s forecast corporate defaults will plunge amid a global economic recovery. Investors withdrew $6.37 billion from junk bond funds until the week ending June 16, when money managers won back a net $164 million, according to EPFR, which tracks global capital flows.
Companies with the highest junk ratings are fundamentally the same as they were before Greece roiled markets and so their debt is undervalued, said Carle, who helps oversee $752 million in Fidelity International’s Asian High-Yield Fund.
‘Substantial’ Compensation
“If you’re an investor that can switch freely between investment-grade and high-yield corporates, now is a good time to switch out of lower-rated investment-grade into the higher- rated high-yield,” Viktor Hjort, a Hong Kong-based credit strategist at Morgan Stanley, said in a phone interview. The compensation for the additional risk is “substantial,” he said.
The Asia-Pacific region’s corporate default rate will “drop sharply” to 3.5 percent this year from 17 percent in 2009 as the region’s economies and credit markets strengthen, Moody’s said on June 13.
“The bulk of defaults are behind us already, so in the medium to long run high-yield is an attractive asset class,” Brayan Lai, a credit analyst at Credit Agricole CIB in Hong Kong, said in an interview. “Will the spread between BBB and BB credits narrow again? Yes, it definitely will.”
--Editors: Will McSheehy, Hugh Chow
To contact the reporter on this story: Shelley Smith in Hong Kong at ssmith118@bloomberg.net
To contact the editor responsible for this story: Will McSheehy at wmcsheehy@bloomberg.net
From Bloomberg Businessweek published on June 20, 2010, 7:48 PM EDT
By Shelley Smith
June 21 (Bloomberg) -- The gap between spreads on Asia’s lowest investment-grade bonds and its top high-yield notes widened to the most in a year, signaling junk debt may rally after investors dumped it amid Europe’s fiscal crisis.
The difference between bonds ranked at least Baa3 by Moody’s Investors Service or BBB- by Standard & Poor’s and those one grade lower at Ba1 or BB+ climbed to 2.8 percentage points after rising to as much as 3.15 percentage points last month, Bank of America Merrill Lynch data show. That’s almost five times the 0.61 percentage point gap of June 2009 and 1.1 percentage points above the one-year average.
“If you can take a long-term view the high-yield space looks pretty attractive,” Gregor Carle, Fidelity International Ltd.’s fixed-income investment director, said in an interview in Hong Kong. “Without a doubt there are opportunities to be found in the gap between investment-grade and high-yield.”
Concern about contagion from Greece’s fiscal crisis triggered five weeks of withdrawals from global speculative- grade bond funds through June 9, according to EPFR Global, even as Moody’s forecast corporate defaults will plunge amid a global economic recovery. Investors withdrew $6.37 billion from junk bond funds until the week ending June 16, when money managers won back a net $164 million, according to EPFR, which tracks global capital flows.
Companies with the highest junk ratings are fundamentally the same as they were before Greece roiled markets and so their debt is undervalued, said Carle, who helps oversee $752 million in Fidelity International’s Asian High-Yield Fund.
‘Substantial’ Compensation
“If you’re an investor that can switch freely between investment-grade and high-yield corporates, now is a good time to switch out of lower-rated investment-grade into the higher- rated high-yield,” Viktor Hjort, a Hong Kong-based credit strategist at Morgan Stanley, said in a phone interview. The compensation for the additional risk is “substantial,” he said.
The Asia-Pacific region’s corporate default rate will “drop sharply” to 3.5 percent this year from 17 percent in 2009 as the region’s economies and credit markets strengthen, Moody’s said on June 13.
“The bulk of defaults are behind us already, so in the medium to long run high-yield is an attractive asset class,” Brayan Lai, a credit analyst at Credit Agricole CIB in Hong Kong, said in an interview. “Will the spread between BBB and BB credits narrow again? Yes, it definitely will.”
--Editors: Will McSheehy, Hugh Chow
To contact the reporter on this story: Shelley Smith in Hong Kong at ssmith118@bloomberg.net
To contact the editor responsible for this story: Will McSheehy at wmcsheehy@bloomberg.net
From Bloomberg Businessweek published on June 20, 2010, 7:48 PM EDT
Wall Street pay should be tied to bonds, critic says
Bonuses for Wall Street's top executives should be tied to a basket of the firm's securities, including bonds, to align managers with all stakeholders and discourage excess leverage and risk, suggests one expert.
Bonuses for Wall Street's top executives should be tied to a basket of the firm's securities, including bonds and stocks, to align managers with all stakeholders and discourage excess leverage and risk, Harvard Law School professor Lucian Bebchuk said.
Under stock-based compensation arrangements, executives are "not exposed to the potential negative consequences that large losses could impose on other contributors to the capital structure, like preferred shareholders, bondholders and depositors," Bebchuk said in a conference call with reporters Tuesday.
Wall Street chief executive officers, including Goldman Sachs' Lloyd Blankfein and JPMorgan Chase's Jamie Dimon, continue to receive pay awards that are made up of restricted stock.
Because banks carry more debt than equity, a better compensation system would also link executives' pay to the performance of bonds and preferred stock, Bebchuk said.
"We could tie the payoffs to executives not just to the value of common shares but to the long-term value of a broader basket of securities," Bebchuk said.
"So, for example, instead of giving executives 3 percent of the value of the firm's common shares, you could give them, say, 1 percent of the aggregate value of the common shares, preferred shares and bonds."
Goldman Sachs, which paid Blankfein a $9 million all-stock bonus for 2009, carried about $64 billion in common equity at the end of December compared with $230 billion in preferred stock and short- and long-term unsecured debt, according to a company filing.
JPMorgan, which paid Dimon $17 million of restricted stock units and options for 2009, had $157 billion in common equity compared with $330 billion in preferred stock, long-term debt and other borrowed funds, a company filing showed.
Bebchuk has been a vocal critic of Wall Street pay practices. His "Wages of Failure" paper last year showed that top officials at Lehman Brothers and Bear Stearns cashed in $2.5 billion in the eight years before their firms collapsed in 2008.
He made his remarks Tuesday on a call hosted by the Investor Responsibility Research Center Institute, a New York-based not-for-profit organization that funds environmental, social and corporate governance research.
In March, the European Parliament's top financial lawmaker made a similar recommendation when she advocated paying bankers' bonuses in subordinated debt rather than shares or cash to limit the type of risk-taking that contributed to the financial crisis.
Sharon Bowles, chairwoman of the assembly's Economic and Monetary Affairs Committee, said bonuses would be held for five years in a pool that the bank could use as capital to absorb losses.
Bankers' bonuses should be capped at 50 percent of their pay, lawmakers on the EU committee said Tuesday, as they voted on tougher capital and remuneration rules for banks.
The plan will be voted on by the whole EU Parliament next month.
From The Seattle Times published on Saturday, June 19, 2010 at 10:00 PM
Bonuses for Wall Street's top executives should be tied to a basket of the firm's securities, including bonds and stocks, to align managers with all stakeholders and discourage excess leverage and risk, Harvard Law School professor Lucian Bebchuk said.
Under stock-based compensation arrangements, executives are "not exposed to the potential negative consequences that large losses could impose on other contributors to the capital structure, like preferred shareholders, bondholders and depositors," Bebchuk said in a conference call with reporters Tuesday.
Wall Street chief executive officers, including Goldman Sachs' Lloyd Blankfein and JPMorgan Chase's Jamie Dimon, continue to receive pay awards that are made up of restricted stock.
Because banks carry more debt than equity, a better compensation system would also link executives' pay to the performance of bonds and preferred stock, Bebchuk said.
"We could tie the payoffs to executives not just to the value of common shares but to the long-term value of a broader basket of securities," Bebchuk said.
"So, for example, instead of giving executives 3 percent of the value of the firm's common shares, you could give them, say, 1 percent of the aggregate value of the common shares, preferred shares and bonds."
Goldman Sachs, which paid Blankfein a $9 million all-stock bonus for 2009, carried about $64 billion in common equity at the end of December compared with $230 billion in preferred stock and short- and long-term unsecured debt, according to a company filing.
JPMorgan, which paid Dimon $17 million of restricted stock units and options for 2009, had $157 billion in common equity compared with $330 billion in preferred stock, long-term debt and other borrowed funds, a company filing showed.
Bebchuk has been a vocal critic of Wall Street pay practices. His "Wages of Failure" paper last year showed that top officials at Lehman Brothers and Bear Stearns cashed in $2.5 billion in the eight years before their firms collapsed in 2008.
He made his remarks Tuesday on a call hosted by the Investor Responsibility Research Center Institute, a New York-based not-for-profit organization that funds environmental, social and corporate governance research.
In March, the European Parliament's top financial lawmaker made a similar recommendation when she advocated paying bankers' bonuses in subordinated debt rather than shares or cash to limit the type of risk-taking that contributed to the financial crisis.
Sharon Bowles, chairwoman of the assembly's Economic and Monetary Affairs Committee, said bonuses would be held for five years in a pool that the bank could use as capital to absorb losses.
Bankers' bonuses should be capped at 50 percent of their pay, lawmakers on the EU committee said Tuesday, as they voted on tougher capital and remuneration rules for banks.
The plan will be voted on by the whole EU Parliament next month.
From The Seattle Times published on Saturday, June 19, 2010 at 10:00 PM
Will Bond Funds Come Back to Bite Investors?
By Janet Morrissey Friday, Jun. 18, 2010
A couple meets with their financial advisor.
David P. Hall / Corbis
Investors, spooked by the roller coaster ride in the equity markets, the "flash crash," and sovereign debt problems overseas, are flocking to bond funds for safety and yield. But industry experts say that investors who wrongly think this niche will weather them safely through the economy's ups and downs may be in for a rude — and costly — awakening.
"I have been saying since January that the bond fund area is a big bubble, but that bubble continues to expand and expand and expand," says Marilyn Cohen, author of "Bonds Now!" and president of Envision Capital Management. "I'm extremely worried because when it does pop, I think it's going to have an ugly ending."
Investors burned in the volatile equity markets have been marching into bond funds en masse over much of the past 18 months. In 2009, about $8 billion flowed out of equity mutual funds while a staggering $365 billion moved into bond funds, according to Madeline Schnapp, director of macroeconomic research at TrimTabs Investment Research. So far in 2010, about $6.5 billion has flowed into stock funds while $155.7 billion has moved into bond funds.
At the same time, many investors, frustrated with the low yields offered on money market accounts and CDs, are moving cash into bond funds. "The miniscule payouts on those [short-term] investments have likely pushed income-hungry investors out the yield curve into bond funds," says Sonya Morris, editorial director of Morningstar's Mutual Funds.
But Cohen frets that many of these wide-eyed investors just don't get it. "I think a lot of the money that's gone into bond funds is first-time money — people that were in CDs and money market funds for decades because that's what they understood and that's where they could have safety and security," she says. "If I'm right and a lot of the money that's flooded into bond funds is uneducated and unsophisticated bond money; it's going to be ugly."
What many recent bond-fund investors may not know is that these funds can be buffeted by rising inflation, credit downgrades, and the daily diet of frightening headlines about sovereign default risk, as each of these things can affect the underlying value of bonds held by the fund. As an example, when inflation skyrocketed and interest rates spiked up in the recession of the late 70s and early 80s, many bond investors lost 40% to 50% of the value of their principal. More recently, when the credit market collapsed in 2008, some bond funds were down 30% or 40%. Although most of these funds bounced back in 2009, it's a wild ride that bond fund investors aren't accustomed to.
There's another risk factor that may not make the financial headlines. Supply and demand for bonds can significantly influence prices. The Federal Reserve bought up a trillion dollars of mortgage bonds over the to help support the financial industry; at some point it will look to unload those bonds, which could send interest rates higher. Also, global demand for U.S. Treasury bonds has been high in the wake of the Greek sovereign debt crisis and concerns about the euro, as many considered Treasuries a safe haven. All of this demand has kept yields down. But once foreign investors move out of Treasuries or the auctions don't go well, demand will dry up and yields will rise, which would be "extremely worrisome" for bond holders, says Cohen. The result could be massive redemptions from bond funds, which would exacerbate the selloff in bonds. "The redemption risk is gi-normous — huge!," says Cohen.
From TIMES published on June 18, 2010
What to Consider Before Investing in Corporate Bonds
On Wednesday, we looked at the returns of corporate bonds and compared them with long-term Treasuries. Today, we’ll look at other factors you should be aware of before investing in corporate bonds.
Taxes
Interest on U.S. government obligations is exempt from state and local taxes. Interest on corporate bonds isn’t. Thus, if you have a state income tax, you need different yields from Treasury bonds and corporate bonds of the same maturity — the corporate yield would have to be higher.
This is why part of the higher yield investors require on corporate bonds over Treasury bonds is related to the difference in tax treatment. The other reasons for the higher required yield are credit risk, liquidity risk and call risk. (Many corporate bonds provide the issuer with the ability to redeem the bond prior to maturity.) Unfortunately, it looks like investors haven’t been adequately compensated for taking these risks over the past 85 years. And the main reason may be the call risk. Martin Fridson’s study, “Original Issue High-Yield Bonds,” found call risk to be a negative contributor to the return on high-yield bonds.
Diversification
Because Treasury securities entail no credit risk, there’s no need for diversification. Thus, you don’t need a mutual fund. Instead, you can buy Treasury securities directly, saving the expense of a mutual fund. Even Vanguard’s Short-Term Investment-Grade Fund (VFSTX) costs 0.26 percent. Other corporate bond funds can cost far more. Also, the market for Treasuries is the most liquid and transparent in the world, keeping trading costs down if you want to buy securities yourself or have an investment advisor firm do that. And you can even buy Treasuries at auctions, getting the same price as institutional investors.
However, as we move beyond Treasuries, the need for diversification increases in direct relationship to the credit rating — the lower the rating, the greater the need for diversification.
The historical evidence suggests you may be best served by excluding corporate bonds from your portfolio, using Treasuries and municipal bonds as appropriate — given their marginal tax rate.
If you need or desire more return from your portfolio, the evidence suggests that you should consider taking that risk with equities, not with corporate bonds or by adding credit risk. However, if you’re going to invest in corporates, the evidence suggests that you should stick with the highest investment grade bonds (as their risks mix better with the risks of equities) and avoid bonds that are callable.
From moneywatch.bnet.com published Jun 4, 2010
How to profit from the end of the junk bond boom
The latest headlines about 'junk' bonds are a classic case in point. You don't need to be a dedicated contrarian investor to get a bit uneasy when you read them.
In fact, there's such a buying frenzy now underway, it could even make sense for more adventurous investors to sell junk bonds 'short'. Here's how...
"Buy to the roar of cannon, sell to the sound of trumpets". This was the advice that British banker Lord Nathan Mayer Rothschild gave during the Napoleonic Wars on how to make the most of your money.
And it applies just as much today as 200 years ago. History shows that the right time to buy into a market is when financial Armageddon looms. And the time to get out is when the jitters have passed, and everyone's feeling upbeat again.
By March 2009, many investors had lost so much money in the stock market that they didn't want to know about buying shares. But if anything, they'd come to hate 'junk' bonds – lower grade IOUs issued by companies to raise cash – even more.
Even although these bonds rank higher in the pecking order for creditors if a business goes bust, prices collapsed as 'risk aversion' among investors soared.
The flip side was that the yields on some of the dodgier corporate issues climbed well into double-digit territory (bonds pay a fixed income, so when prices fall, the income yield rises). Basically, markets were saying that we were about to see an avalanche of bond issuers defaulting on their interest bills.
Some of these recession-induced jitters were understandable. Company cash flows, particularly in the US and Europe, were being savagely squeezed by falling sales and lower profit margins. In fact, by the end of 2009, the global default rate for high-yield debt hit 13%. In other words, one in seven junk bond issuers proved unable to service its debts.
Despite everything, junk bond prices have surged
But look what's happened to junk bond prices over the past year. March 2009 was, with the benefit of 20/20 hindsight, exactly the time to buy into the junk bond market, despite all those concerns.
Prices have surged, so yields have dropped sharply. High-yield bonds now pay out an average of 8.6%, says Bank of America Merrill Lynch. This may still look like a decent return, but it's actually the lowest since October 2007. That, by the way, was just before financial markets fell apart last time.
And 'spreads' – the difference between yields on junk bonds and US Treasuries – have now narrowed to their lowest levels since December 2007.
Is there much justification for this? Well, there's been a slight improvement in terms of defaults. By the end of this year's first quarter, the default ratio had dropped to one in ten (from one in seven), and is forecast to fall further throughout 2010. So fewer companies are under the cosh. But a 10% default rate is still hardly anything to cheer about.
Yet now, it seems investors just can't get their hands on enough junk. These bonds account for "the biggest share of corporate debt sales on record" reports Bryan Keogh in BusinessWeek. "Global high-yield bond sales hit $91bn this year, or 12% of total issuance, almost double last year's share, according to Bloomberg data. Investors wagering on an economic rebound are snapping up securities even from first-time issuers".
In other words, investments that couldn't be sold for love nor money a year ago are currently being bought with relish. Yet potential returns are now much lower, and some of the sellers have no market track record.
"Most of the major concerns seem to be gone", Calvert Asset Management's James Lee tells Bloomberg. "It's a self-fulfilling cycle. Cash is coming into high-yield, and high-yield managers are putting cash to work". Indeed, "it's hard to find debt that investors don't like", says Agnes Crane on Sify Finance.
Alarm bells should be ringing for contrarians
Cue Rothschild's trumpet blasts – it's time for contrarians to get worried. "Lenders don't seem to be good learners", says Crane. "To judge from the credit market, the 2008-9 crisis might never have happened. The current buying frenzy looks like a return to an old bad habit".
There may be plenty of junk bond buyers chasing yields down right now, but there are plenty more borrowers in the pipeline. We flagged in the magazine last month that $700bn of dodgy debt in the US alone will mature between 2012 and 2014, and so will need refinancing: Why 2012 really is doomsday.
Compared with just $21bn maturing this year, that will be "an extraordinary surge", says Nelson D Schwartz in The New York Times.
More corporate borrowers will have to compete with each other, as well as with cash-strapped governments, for whatever funds will be around. And as lending risks rise, much higher junk bond yields around the world look likely. Borrowers will "get crowded out or will have to pay significantly more", says Tom Atteberry of First Pacific Advisors.
All bad news for junk bond prices. But as an investor, what should you do?
How to cash in on the the junk bond boom
Clearly, not joining in the junk bond party will stop you losing your cash in it. But there is also a way you can make money here.
The ITraxx Crossover 5-year Total Return Index is a measure of the default risk of 50 of the most liquid European High Yield corporate bonds. As investors' fear of default falls, and junk bond prices rise, the Index goes up, as has happened recently. The Index is almost at its highest level since Bloomberg records began in 2006.
But if default worries resurface and junk bond prices decline, the Index will fall. And if you want to buy something that will take advantage of such a drop, the less than snappily titled db x-trackers iTraxx Crossover 5-year Short Total Return Index ETF (GY: XTC5) should do the trick. That's because it's effectively selling the Crossover Index 'short'.
It isn't without risk. Selling short rarely is, and you lose money if the index keeps rising. It's also quoted in euros, so there's currency risk too, if the pound recovers. It's also worth having a look at the detail of the ETF's construction to ensure you understand how it works. But if you believe the junk bond boom is nearly over, this could be a good way to cash in.
From money week published on Apr 12, 2010
Four Best Ways To Invest In Bonds
Michael Schmidt, 04.30.10, 06:56 PM EDT
These strategies will help you build your portfolio.
For the casual observer, bond investing would appear to be as simple as buying the bond with the highest yield. While this works well when shopping for a certificate of deposit (CD) at the local bank, it's not that simple in the real world. There are multiple options available when it comes to structuring a bond portfolio, and each strategy comes with its own tradeoffs. The four principal strategies used to manage bond portfolios are:
--Passive, or "buy and hold"
--Index matching, or "quasi passive"
--Immunization, or "quasi active"
--Dedicated and active
Passive Bond Strategy
The passive buy-and-hold investor is typically looking to maximize the income generating properties of bonds. The premise of this strategy is that bonds are assumed to be safe, predictable sources of income. Buy and hold involves purchasing individual bonds and holding them to maturity. Cash flow from the bonds can be used to fund external income needs or can be reinvested in the portfolio into other bonds or other asset classes. In a passive strategy, there are no assumptions made as to the direction of future interest rates and any changes in the current value of the bond due to shifts in the yield are not important.
The bond may be originally purchased at a premium or a discount, while assuming that full par will be received upon maturity. The only variation in total return from the actual coupon yield is the reinvestment of the coupons as they occur. On the surface, this may appear to be a lazy style of investing, but in reality passive bond portfolios provide stable anchors in rough financial storms. They minimize or eliminate transaction costs, and if originally implemented during a period of relatively high interest rates, they have a decent chance of outperforming active strategies.
One of the main reasons for their stability is the fact that passive strategies work best with very high-quality, non-callable bonds like government or investment grade corporate or municipal bonds. These types of bonds are well suited for a buy-and hold strategy as they minimize the risk associated with changes in the income stream due to embedded options, which are written into the bond's covenants at issue and stay with the bond for life. Like the stated coupon, call and put features embedded in a bond allow the issue to act on those options under specified market conditions.
Ladders are one of the most common forms of passive bond investing. This is where the portfolio is divided into equal parts and invested in laddered style maturities over the investor's time horizon. Dividing the principal into equal parts provides a steady equal stream of cash flow annually.
Indexing Bond Strategy
Indexing is considered to be quasi-passive by design. The main objective of indexing a bond portfolio is to provide a return and risk characteristic closely tied to the targeted index. While this strategy carries some of the same characteristics of the passive buy-and-hold, it has some flexibility. Just like tracking a specific stock market index, a bond portfolio can be structured to mimic any published bond index. One common index mimicked by portfolio managers is the Lehman Aggregate Bond Index.
Due to the size of this index, the strategy would work well with a large portfolio due to the number of bonds required to replicate the index. One also needs to consider the transaction costs associated with not only the original investment, but also the periodic rebalancing of the portfolio to reflect changes in the index.
Immunization Bond Strategy
This strategy has the characteristics of both active and passive strategies. By definition, pure immunization implies that a portfolio is invested for a defined return for a specific period of time regardless of any outside influences, such as changes in interest rates. Similar to indexing, the opportunity cost of using the immunization strategy is potentially giving up the upside potential of an active strategy for the assurance that the portfolio will achieve the intended desired return.
As in the buy-and-hold strategy, by design the instruments best suited for this strategy are high-grade bonds with remote possibilities of default. In fact, the purest form of immunization would be to invest in a zero-coupon bond and match the maturity of the bond to the date on which the cash flow is expected to be needed. This eliminates any variability of return, positive or negative, associated with the reinvestment of cash flows.
Duration, or the average life of a bond, is commonly used in immunization. It is a much more accurate predictive measure of a bond's volatility than maturity. This strategy is commonly used in the institutional investment environment by insurance companies, pension funds and banks to match the time horizon of their future liabilities with structured cash flows. It is one of the soundest strategies and can be used successfully by individuals. For example, just like a pension fund would use an immunization to plan for cash flows upon an individual's retirement, that same individual could build a dedicated portfolio for his or her own retirement plan.
Active Bond Strategy
The goal of active management is maximizing total return. Along with the enhanced opportunity for returns obviously comes increased risk. Some examples of active styles include interest rate anticipation, timing, valuation and spread exploitation, and multiple interest rate scenarios. The basic premise of all active strategies is that the investor is willing to make bets on the future rather than settle with what a passive strategy can offer.
Conclusion
There are many strategies for investing in bonds that investors can employ. The buy-and-hold approach appeals to investors who are looking for income and are not willing to make predictions. The middle-of-the-road strategies include indexation and immunization, both of which offer some security and predictability. Then there is the active world, which is not for the casual investor. Each strategy has its place and when implemented correctly, can achieve the goals for which it was intended.
From FORBES published on 04.30.10, 06:56 PM EDT
These strategies will help you build your portfolio.
For the casual observer, bond investing would appear to be as simple as buying the bond with the highest yield. While this works well when shopping for a certificate of deposit (CD) at the local bank, it's not that simple in the real world. There are multiple options available when it comes to structuring a bond portfolio, and each strategy comes with its own tradeoffs. The four principal strategies used to manage bond portfolios are:
--Passive, or "buy and hold"
--Index matching, or "quasi passive"
--Immunization, or "quasi active"
--Dedicated and active
Passive Bond Strategy
The passive buy-and-hold investor is typically looking to maximize the income generating properties of bonds. The premise of this strategy is that bonds are assumed to be safe, predictable sources of income. Buy and hold involves purchasing individual bonds and holding them to maturity. Cash flow from the bonds can be used to fund external income needs or can be reinvested in the portfolio into other bonds or other asset classes. In a passive strategy, there are no assumptions made as to the direction of future interest rates and any changes in the current value of the bond due to shifts in the yield are not important.
The bond may be originally purchased at a premium or a discount, while assuming that full par will be received upon maturity. The only variation in total return from the actual coupon yield is the reinvestment of the coupons as they occur. On the surface, this may appear to be a lazy style of investing, but in reality passive bond portfolios provide stable anchors in rough financial storms. They minimize or eliminate transaction costs, and if originally implemented during a period of relatively high interest rates, they have a decent chance of outperforming active strategies.
One of the main reasons for their stability is the fact that passive strategies work best with very high-quality, non-callable bonds like government or investment grade corporate or municipal bonds. These types of bonds are well suited for a buy-and hold strategy as they minimize the risk associated with changes in the income stream due to embedded options, which are written into the bond's covenants at issue and stay with the bond for life. Like the stated coupon, call and put features embedded in a bond allow the issue to act on those options under specified market conditions.
Ladders are one of the most common forms of passive bond investing. This is where the portfolio is divided into equal parts and invested in laddered style maturities over the investor's time horizon. Dividing the principal into equal parts provides a steady equal stream of cash flow annually.
Indexing Bond Strategy
Indexing is considered to be quasi-passive by design. The main objective of indexing a bond portfolio is to provide a return and risk characteristic closely tied to the targeted index. While this strategy carries some of the same characteristics of the passive buy-and-hold, it has some flexibility. Just like tracking a specific stock market index, a bond portfolio can be structured to mimic any published bond index. One common index mimicked by portfolio managers is the Lehman Aggregate Bond Index.
Due to the size of this index, the strategy would work well with a large portfolio due to the number of bonds required to replicate the index. One also needs to consider the transaction costs associated with not only the original investment, but also the periodic rebalancing of the portfolio to reflect changes in the index.
Immunization Bond Strategy
This strategy has the characteristics of both active and passive strategies. By definition, pure immunization implies that a portfolio is invested for a defined return for a specific period of time regardless of any outside influences, such as changes in interest rates. Similar to indexing, the opportunity cost of using the immunization strategy is potentially giving up the upside potential of an active strategy for the assurance that the portfolio will achieve the intended desired return.
As in the buy-and-hold strategy, by design the instruments best suited for this strategy are high-grade bonds with remote possibilities of default. In fact, the purest form of immunization would be to invest in a zero-coupon bond and match the maturity of the bond to the date on which the cash flow is expected to be needed. This eliminates any variability of return, positive or negative, associated with the reinvestment of cash flows.
Duration, or the average life of a bond, is commonly used in immunization. It is a much more accurate predictive measure of a bond's volatility than maturity. This strategy is commonly used in the institutional investment environment by insurance companies, pension funds and banks to match the time horizon of their future liabilities with structured cash flows. It is one of the soundest strategies and can be used successfully by individuals. For example, just like a pension fund would use an immunization to plan for cash flows upon an individual's retirement, that same individual could build a dedicated portfolio for his or her own retirement plan.
Active Bond Strategy
The goal of active management is maximizing total return. Along with the enhanced opportunity for returns obviously comes increased risk. Some examples of active styles include interest rate anticipation, timing, valuation and spread exploitation, and multiple interest rate scenarios. The basic premise of all active strategies is that the investor is willing to make bets on the future rather than settle with what a passive strategy can offer.
Conclusion
There are many strategies for investing in bonds that investors can employ. The buy-and-hold approach appeals to investors who are looking for income and are not willing to make predictions. The middle-of-the-road strategies include indexation and immunization, both of which offer some security and predictability. Then there is the active world, which is not for the casual investor. Each strategy has its place and when implemented correctly, can achieve the goals for which it was intended.
From FORBES published on 04.30.10, 06:56 PM EDT
The Best All-in-One Bond Funds
Our favorites stir in some foreign and domestic bonds to spread your risk and boost your return.
By Elizabeth Ody, Associate Editor
If you didn't own bonds over the past ten years, you missed out. in a decade during which U.S. stocks experienced two major busts, almost every major category of bonds returned at least 6% annualized -- and did so with much less drama. But as with any aspect of investing, the past is not necessarily prologue. And the performance of the past ten years certainly doesn't mean you can invest willy-nilly in any segment of the bond market and expect to do as well over the next ten.
The bond market includes at least a dozen categories, from Treasuries to speculative high-yield corporates to IOUs issued by foreign governments and companies. Most bond mutual funds specialize in only one segment of this vast marketplace. So if you want broad coverage, you might choose to buy a collection of funds -- those that specialize in, say, Treasuries, mortgages and junk, and in short-term and long-term maturities.
But there is another way to cover the bases, and it spares you the guesswork. Some bond funds have the flexibility to invest in any part of the fixed-income marketplace, both here and abroad, in both high-grade and low-quality stuff, and in maturities short, long and in between. Below, we identify five of the best all-in-one funds, sometimes also called multisector funds. Run by some of the brightest bond strategists, these funds are not for the faint of heart. The typical flexible bond fund is two-thirds more volatile than the typical domestic-bond index fund. And because these funds truly can go anywhere in the bond market, their composition may not be the same from one quarter to the next. Still, risk-averse investors should consider holding a multisector fund alongside their high-quality bonds, and the more adventurous could justify putting all their bond money into one or two of these funds.
How much of your portfolio should be in bonds? If you can't stomach a lot of volatility and need current income, you might place all of your investments in bonds. But if you're a long-term investor, we'd encourage you to hold at least 20% to 30% of your assets in stocks. By the same token, even aggressive investors could put as much as 20% of their money in bonds. To help you find the fund that's right for you, we list our picks by the type of investor they're best suited for.
For total return
Dan Fuss and his team at Loomis Sayles Bond (symbol LSBRX) are widely regarded as some of the best bond managers on the planet, thanks to their fund's record of delivering the kinds of returns you expect from stocks over the long term. Fuss and co-managers Kathleen Gaffney, Matt Eagan and Elaine Stokes build the portfolio with a blend of big-picture economic analysis, research on individual bonds and a contrarian's instinct for investing in areas others won't touch.
When the strategy works, it produces solid results. But when other bond funds scrape their chin, Loomis gets a concussion. In 2008, for example, the team was far too early in anticipating a recovery in low-quality corporate bonds. As a result, the fund dropped 22% that year (compared with an average loss of 16% for multisector funds).
But since then, Loomis Sayles Bond has more than made up for lost ground. It soared 37% in 2009, and its 8.6% annualized return over the past ten years beats more than 90% of its peers (all returns are through December 31; see our bond-fund and bond-ETF tables for more data).
Recently, the fund's managers have grown cautious. Fuss believes that the U.S. is at the start of a long-term rise in interest rates, so the managers are gradually trimming the fund's average maturity to lessen its susceptibility to higher yields. The team also favors debt denominated in so-called commodity currencies, such as the Canadian and Australian dollars, which tend to move in tandem with commodity prices and can provide a hedge against both inflation and a sinking dollar (see Make a Buck Off a Sagging Dollar).
For interest-rate bears
Fuss and colleagues aren't alone in their concern that rising interest rates will erode bond returns over the next few years (bond prices move inversely with rates). Trimming maturities is one way of minimizing this risk. But Chris Dialynas, manager of Pimco Unconstrained Bond (PUBDX), has the flexibility to go a leap further by effectively seeking to make money from rising rates. The fund's prospectus allows him to position it in such a way that Unconstrained Bond could gain as much as 3% if interest rates were to rise one percentage point.
That's not to say the fund is a one-trick pony. The members of Pimco's lead strategy team, including Dialynas and Pimco's chief investment officers, Bill Gross and Mohamed El-Erian, generate the investment ideas that populate this and other Pimco funds. Pimco Unconstrained Bond will tend to reflect the same bets as flagship Pimco Total Return but in a more concentrated, more aggressive fashion. The only significant constraint on Dialynas is that the fund must maintain an average credit quality of at least triple-B, meaning he can't go overboard on junk bonds.
That's just as well, because Dialynas believes that junk prices today reflect an overly rosy view of the economy and corporate profits. He also thinks chances are good that the Federal Reserve's easy-money policy will eventually stoke inflation. In that case, his flexibility on interest rates could come in awfully handy.
For income
Next to Dan Fuss's nearly two decades at Loomis Sayles, Steve Huber's one-year tenure at T. Rowe Price Strategic Income (PRSNX) appears unimpressive. But Price has a superb record as a bond manager -- of its 11 taxable-bond funds that have been around at least ten years, nine have beaten the average return of their peers over the period. Four other Price sector experts join Huber on the team that determines the fund's allocation to different bond classes. Picking individual bonds then falls to teams of specialists.
Today, says Huber, "we're in more of a coupon-clipping environment" than in 2009, when rapidly ascending bond prices generated handsome double-digit returns in many sectors. He's relatively bullish on corporate bonds, figuring that many companies have cut costs and refinanced their higher-yielding debt, making it easier for them to meet current obligations. Huber is paring back exposure to mortgage bonds, in anticipation of the U.S. Treasury halting its mortgage-purchase program at the end of the first quarter of 2010.
As many a Jackson Pollock wannabe has sadly discovered, our brains' creative juices tend to flow far better when we operate within a framework of constraints as opposed to working with unfettered creative liberty. Perhaps our minds also need limits when making investing decisions. That might help explain the bang-up record at Fidelity Strategic Income (FSICX), whose managers work within rigid rules governing the fund's makeup.
Strategic Income is shaped like a barbell, with assets split between risky and safe issues. Lead managers Joanna Bewick and Chris Sharpe begin with a neutral allocation of 30% U.S. government debt, 15% developed-market government debt, 40% U.S. junk bonds and 15% emerging-markets debt. "We don't compromise by buying anything in the middle," Bewick says. Although that restriction means the fund can miss out on attractive opportunities, she says, "it makes for simplicity and clarity of decision-making."
Bewick and Sharpe tweak the allocations to adjust to market conditions and then leave the selection of individual bonds to Fidelity specialists. Ordinarily, Bewick and Sharpe don't shift the fund's mix between "safe" and "risky" assets by more than a few percentage points, but when the market calls for a bold move, they can oblige. For example, the team began shifting toward safe U.S.- and foreign-government bonds at the start of 2007, before subprime had become a household word. That allotment peaked at 60%, or 15 percentage points above the neutral weighting, in September 2008, helping to contain losses that year to 11.4%. Lately, the fund is close to its neutral allocations, with a bearish stance on U.S.-government debt and a bullish stance on junk bonds.
For extra spice
Carl Kaufman and Simon Lee arenUt bound by any explicit constraints in managing Osterweis Strategic Income (OSTIX). But they self-impose one rule: Buy what you know. So they usually avoid mortgages and bonds denominated in foreign currencies, the two areas they feel ill-equipped to judge. Because Kaufman is a former convertible-bond specialist, he and Lee tend to keep a significant portion of assets (15% to 40%) in converts. These are bonds that can be converted into a set number of the issuer's common shares and that will behave like bonds or like stocks at different times.
The managers begin their process by taking a 10,000-foot view of the bond market and the economy, seeking to identify the greatest risks for bonds. "Over the next couple of years, that risk is probably rising interest rates," Kaufman says. Then they look for attractively priced bonds that are likely to hold up against that risk. And that's leading them to buy short-term, high-yield bonds and convertible bonds that can be redeemed with the issuer for a set price within the next two to four years.
With its heavy bias toward convertibles and ordinary corporate bonds, Osterweis isn't as diversified as the other funds on this list. But its record suggests that it's worthy of your attention anyway. From its inception in 2002 through December 31, the fund returned 8.2% annualized, or two percentage points better than the average flexible bond fund, with one-third less volatility.
Three moves to make now
Use this checklist to give your bond portfolio a tune-up.
Allocate. Bonds have performed far better than stocks over the past few years, so your bond holdings may have appreciated beyond your target weighting. Adjust as necessary.
Diversify. Don’t just sit on Treasuries. Diversify with one or two of the funds recommended in this story, or fill in the gaps in your bond portfolio with the exchange-traded funds described on the next page.
Strategize. The linked forces of rising interest rates, inflation and a falling dollar threaten to eat away at your bond returns over the next several years. Keeping maturities short will help insulate you from rising rates, while owning some bonds denominated in foreign currencies can help protect you from the two other developments.
From kiplinger's Personal Finance Magazine, March 2010
TREASURIES-Bonds dip on better jobs picture
* Prices slip on eve of May employment report
Bonds
* Fed's Bernanke says high unemployment remains a concern
* Treasury to sell $70 bln 3Y, 10Y, 30Y supply next week (Updates comment, market action, changes byline)
By Ellen Freilich
NEW YORK, June 3 (Reuters) - U.S. Treasury debt prices fell on Thursday as the stock market edged higher and traders cut holdings of safe-haven government bonds in anticipation of a robust May payrolls report on Friday.
Stocks were in the minus column for much of the session but crept into positive territory late in the day, and bond prices fell as the safety bid waned and investors took on riskier assets.
"When stocks fell, Treasuries rebounded, and when stocks moved up, Treasuries headed lower, but the bond market's overriding consideration was positioning for Friday's report on May U.S. job growth, which is expected to be quite strong," said John Canavan, analyst at Stone & McCarthy Research Associates in Princeton, New Jersey.
Benchmark 10-year notes US10YT=RR fell 7/32 in price to 101-3/32. Their yield, which moves inversely to price, rose to 3.37 percent, up from 3.34 percent on Wednesday.
Some U.S. labor market data released this week appeared to support expectations for a robust half-a-million increase in jobs in the government's payrolls report due on Friday.
A report from ADP Employer Services on Thursday said U.S. private employers added 55,000 jobs in May and an upwardly revised 65,000 in April. For more, see [ID:nEAP102300]
The Institute for Supply Management reported its labor gauge of U.S. services industries rose, with its employment index at its highest level since December, 2007, while the government said U.S. claims for initial jobless benefits fell moderately last week. [ID:nEAP101300] [ID:nOAT004637]
The median May job growth estimate culled from a Reuters poll of economists was 513,000, after 290,000 new jobs were added to payrolls in April.
"The labor market appears to be on the mend," said Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities in New York. LaVorgna estimated that U.S. non-farm payrolls expanded by 600,000 jobs in May, about two-thirds of which would be due to temporary Census hiring.
His noted his forecast for private sector job creation of 200,000 is actually slightly weaker than April private sector job growth of 231,000.
"Heightened economic concerns last month related to financial market gyrations and sovereign risks may have caused some employers to postpone hiring they might otherwise have done in May," he said.
LaVorgna said the change in private payrolls would matter most to policymakers, and that the Federal Reserve needs to see "a steady string" of monthly payroll gains topping 300,000, excluding temporary Census workers.
Traders said if private sector hiring comes in stronger than people expect, Treasuries could succumb to further selling, especially ahead of new supply next week.
"We would have a reason for equities to run up and bonds to sell off," said Justin Hoogendoorn, managing director of U.S. fixed income at BMO Capital Markets in Chicago.
Still, even as the economy has started to produce new jobs, unemployment is stuck at a high level, which remains a top concern for the Fed policy-makers.
Fed Chairman Ben Bernanke told a small business group in Michigan that the jobless rate, which was at 9.9 percent in April, is a "particularly difficult issue." [ID:nWAL3HE67L]
Benchmark yields touched two-week highs on encouraging jobs data and stocks rose briefly on lessened anxiety over Europe's sovereign debt crisis.
"Players continue to watch the euro as a measure for the broader outlook for the European economy, but it hasn't been doing much for days," Canavan said. "It's near its recent lows, but it has settled into a range in recent days."
Traders also eyed the supply coming to market next week.
The U.S. Treasury said it will sell a combined $70 billion of coupon-bearing securities next week: $36 billion of three-year notes, $2 billion less than in May, as well as reopened issues of 10- and 30-year securities.
The government began paring the auction sizes of shorter-dated debt in May, partly because tax receipts have increased in recent months. (Additional reporting by Richard Leong; Editing by Chizu Nomiyama)
From REUTERS published on Thu Jun 3, 2010 5:09pm EDT
Bonds
* Fed's Bernanke says high unemployment remains a concern
* Treasury to sell $70 bln 3Y, 10Y, 30Y supply next week (Updates comment, market action, changes byline)
By Ellen Freilich
NEW YORK, June 3 (Reuters) - U.S. Treasury debt prices fell on Thursday as the stock market edged higher and traders cut holdings of safe-haven government bonds in anticipation of a robust May payrolls report on Friday.
Stocks were in the minus column for much of the session but crept into positive territory late in the day, and bond prices fell as the safety bid waned and investors took on riskier assets.
"When stocks fell, Treasuries rebounded, and when stocks moved up, Treasuries headed lower, but the bond market's overriding consideration was positioning for Friday's report on May U.S. job growth, which is expected to be quite strong," said John Canavan, analyst at Stone & McCarthy Research Associates in Princeton, New Jersey.
Benchmark 10-year notes US10YT=RR fell 7/32 in price to 101-3/32. Their yield, which moves inversely to price, rose to 3.37 percent, up from 3.34 percent on Wednesday.
Some U.S. labor market data released this week appeared to support expectations for a robust half-a-million increase in jobs in the government's payrolls report due on Friday.
A report from ADP Employer Services on Thursday said U.S. private employers added 55,000 jobs in May and an upwardly revised 65,000 in April. For more, see [ID:nEAP102300]
The Institute for Supply Management reported its labor gauge of U.S. services industries rose, with its employment index at its highest level since December, 2007, while the government said U.S. claims for initial jobless benefits fell moderately last week. [ID:nEAP101300] [ID:nOAT004637]
The median May job growth estimate culled from a Reuters poll of economists was 513,000, after 290,000 new jobs were added to payrolls in April.
"The labor market appears to be on the mend," said Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities in New York. LaVorgna estimated that U.S. non-farm payrolls expanded by 600,000 jobs in May, about two-thirds of which would be due to temporary Census hiring.
His noted his forecast for private sector job creation of 200,000 is actually slightly weaker than April private sector job growth of 231,000.
"Heightened economic concerns last month related to financial market gyrations and sovereign risks may have caused some employers to postpone hiring they might otherwise have done in May," he said.
LaVorgna said the change in private payrolls would matter most to policymakers, and that the Federal Reserve needs to see "a steady string" of monthly payroll gains topping 300,000, excluding temporary Census workers.
Traders said if private sector hiring comes in stronger than people expect, Treasuries could succumb to further selling, especially ahead of new supply next week.
"We would have a reason for equities to run up and bonds to sell off," said Justin Hoogendoorn, managing director of U.S. fixed income at BMO Capital Markets in Chicago.
Still, even as the economy has started to produce new jobs, unemployment is stuck at a high level, which remains a top concern for the Fed policy-makers.
Fed Chairman Ben Bernanke told a small business group in Michigan that the jobless rate, which was at 9.9 percent in April, is a "particularly difficult issue." [ID:nWAL3HE67L]
Benchmark yields touched two-week highs on encouraging jobs data and stocks rose briefly on lessened anxiety over Europe's sovereign debt crisis.
"Players continue to watch the euro as a measure for the broader outlook for the European economy, but it hasn't been doing much for days," Canavan said. "It's near its recent lows, but it has settled into a range in recent days."
Traders also eyed the supply coming to market next week.
The U.S. Treasury said it will sell a combined $70 billion of coupon-bearing securities next week: $36 billion of three-year notes, $2 billion less than in May, as well as reopened issues of 10- and 30-year securities.
The government began paring the auction sizes of shorter-dated debt in May, partly because tax receipts have increased in recent months. (Additional reporting by Richard Leong; Editing by Chizu Nomiyama)
From REUTERS published on Thu Jun 3, 2010 5:09pm EDT
Bonds: Avoid the next great bubble
By Paul J. LimJune 4, 2010: 4:46 AM ET
(Money Magazine) -- As manias go, this one is different. Your neighbors aren't coming up to you at cocktail parties bragging about making a killing in bonds. No one is flipping fixed income for quick profit. And no talk-radio guru is shouting that bonds will be the only investment left standing after the next financial Armageddon.
Don't let the lack of fanfare fool you. A projected $380 billion will pour into bond funds this year, more than went into domestic stock funds in the past decade. That's on top of a record $376 billion last year.
"The bond market is a bubble," says Robert Froehlich, senior managing director of the Hartford Financial Services Group. "And it's getting ready to burst." One major reason: Despite the recent rally in treasury bond prices and slide in yields -- due to fears over the European debt crisis -- the long-term direction for interest rates is headed higher.
What's inflating the bubble
Like all financial manias, this one is being fueled by a combination of fear and greed.
James Stack, a market historian and president of InvesTech Research, notes that many baby boomers who have stampeded into bond funds did so in reaction to their stock losses since the financial crisis began in 2008.
"It's post-traumatic shock," he says. Even with the rebound in equities since March 2009, "investors fear putting money into the stock market because they have a newfound respect for the risk equities pose."
Over the past decade, holding bonds was considerably safer than holding stocks. After the tech bubble burst in 2000 and equities lost almost half their value over the next three years, corporate bonds surged nearly 50%. And when the global financial crisis erupted two years ago, U.S. Treasury bonds were just about the only investment to retain value. The flight to safety in recent weeks, driven by concerns over Europe's mounting budget problems, has moved investors back into treasuries for the time being yet again.
On top of that, few investors know what it's like to live through a true bear market in bonds. Fueled by falling interest rates (long-term rates were as high as 15% in the early '80s), the current bull market has lasted for 30 years.
The resulting sense of safety -- the belief that bonds don't go bad -- is contributing to this feeding frenzy in fixed-income funds and ETFs. And all that money flowing in has made bonds very expensive.
You can see how frothy Treasuries are by calculating a P/E of sorts for bonds; just divide the bond's price by its current yield, not by earnings. At a price of around $100 and a yield of 3.3% -- up from 2% in december 2008 -- 10-year Treasurys have a P/E of 30. That's around twice their historical level.
It's true that bonds are less volatile than stocks. But in fact they lose money just as often as equities do. "I don't think the public understands they can lose money in bond funds," says James Swanson, chief investment strategist at MFS, an asset-management firm in Boston.
So that's the fear part. The greed part comes from an entirely different group of people: safety-loving folks who normally park their money in cash, such as bank savings accounts, CDs, or money-market funds. Fed up with the meager interest rates those accounts are paying these days -- the average taxable money-market fund yields 0.03% -- they're venturing into short-term bond funds to eke out a bit more yield.
Why the bubble could burst
One part of the bubble is already leaking air: long-term government bond funds. Because they invest in supersafe U.S. Treasuries and other forms of government-backed debt, they were a popular place to hide during the mortgage meltdown.
But when the economy began improving and rates on 10-year Treasurys began rising (from about 2% at the end of 2008 to as high as 4% in April before slipping to 3.3% today), these funds started suffering. In fact, the Vanguard long-term Treasury bond fund fell 12% in 2009 and, despite the recent run up in Treasury securities, is still down 5% since the end of 2008.
Experts say that's just the beginning. Here are the major factors that could harm bonds further.
Rising interest rates. "Rising rates are the biggest concern out there for bonds," says Mario De Rose, fixed-income strategist for the brokerage Edward Jones in St. Louis. That's because they make older, lower-yielding bonds that you or your funds own look less attractive compared with newer securities.
Let's say you bought a 10-year Treasury at the current rate of 3.3%. If rates rose to, say, 4.3%, the price of the bond would fall by nearly 8%, according to T. Rowe Price. So even though you'd be earning interest income, your actual total return would be 4%.
Alas, even if rates continue to tick down for a bit, the long-term trend is up. Economists at Standard & Poor's think the yield on 10-year Treasuries will jump to 5.3% by 2012; Froehlich of Hartford predicts it could hit 6.5% much sooner than that.
In a rising-rate environment, individual bonds have an edge over bond funds. You can simply hold individual bonds to maturity, at which point the issuer promises to give you back your original investment in full. That's impossible with funds, which hold lots of issues and are constantly buying and selling. Fixed-income funds can still make sense for a lot of reasons. But "they are the worst investment when it comes to rising rates," says InvesTech's Stack.
With the federal deficit now projected to exceed $1 trillion this year and next, the Federal Reserve has little choice but to effectively crank up the amount of money in circulation. So there's a real chance that inflation -- nonexistent now -- could start running as hot as 5% in the next few years. If that happens, the real return on any bond yielding below 5% would be wiped out entirely.
Lingering doubts about the economic recovery. Most experts believe that the global economy is on the mend. But ongoing struggles in the housing market, a rise in mortgage defaults among owners of commercial properties, or a spread of the debt crisis in Europe are still possible, says Jeremy Grantham, chief investment officer of GMO, an asset-management firm in Boston. Any of those could damage the financial health of the countries or companies that issue bonds.
If investors become concerned that certain bond issuers are less creditworthy, their debt will become less desirable, weighing down bond prices. For example, thanks to growing worries about the debt crisis in Greece, Spain, and Portugal, many funds that specialize in European bonds are down so far this year. American Century International Bond, with around two-thirds of its assets in debt issued from European countries, has fallen more than 7%.
Panic selling. In today's low-rate environment, some bond fund managers -- even those who run short-term funds -- are taking extra risks "to reach for extra yield," says Russel Kinnel, director of fund research for Morningstar.
For instance, they might invest in bonds issued by entities of questionable financial health. The results aren't always pretty. In 2008 several short and ultrashort funds posted staggering losses (35% in the case of Schwab YieldPlus) as the credit crisis crushed bonds that they held.
Remember all those Johnny-come-latelies who recently moved from money-market funds to bond funds? At the first sign of trouble, many of them are likely to flee back to cash, warns Marilyn Cohen, president of Envision Capital Management, an advisory firm in Los Angeles that manages bonds for individual investors.
If the selling is severe enough, fund managers could be forced to dump bonds to meet redemptions, making other bond investors' losses worse. That risk is especially high with bonds that trade infrequently. Holders might accept fire-sale prices to get out in a hurry -- that rush to sell exacerbated losses suffered in the credit crisis.
How to protect yourself
Does this mean you should junk your bond holdings? No. If used properly, bonds will help you diversify your portfolio and generate much-needed income. Instead, try these strategies to protect yourself from the worst effects of a bond meltdown.
Shorten your durations. "Duration" measures how sensitive an investment is to interest rate changes. If a bond or bond fund has a duration of five years, for example, its price is likely to rise around 5% if interest rates fall by one percentage point. Conversely, if rates rise by one point, the price will fall by around 5%. The longer the duration, the higher the risk of losses. In this rising-rate environment, MFS's Swanson advises investors to stick with durations of around four years or less.
If you own a long-term government bond fund, consider replacing it with a shorter-term one with a duration in Swanson's target zone. Also check out the duration of the intermediate- and short-term funds you already own. You can do so by going to Morningstar.com, typing in your fund ticker, and clicking the Portfolio tab.
There can be significant variation within categories. While the average duration of a typical intermediate-term government bond fund, for example, is about four years, that of Managers Intermediate Duration Government (MGIDX).
Buy TIPS rather than regular Treasuries. Treasury Inflation-Protected Securities yield significantly less than regular Treasury bonds right now (around 1.3% for 10-year TIPS vs. 3.3% for regular Treasuries of similar maturities). But TIPS have one big advantage: The interest they pay is adjusted to reflect changes in the consumer price index.
These days it makes sense to buy individual TIPS rather than mutual funds that hold them. For one thing, it's easy to buy the bonds directly from Uncle Sam at Treasurydirect.gov. You'll pay no commissions or other fees. And the minimum investment is just a hundred bucks. As for maturity, choose one of no more than 10 years. And make sure you won't need the principal back before the end date.
Shift some short-term money to floating-rate bank funds. These funds invest in short-term, adjustable-rate bank loans made to corporations. Because such loans often reset every one to six months, "you get more income as rates rise," says Brady. The average bank loan fund has returned around 3% so far this year, compared with 2% for the average short-term bond fund.
But banks make many of these floating-rate loans to companies with less-than-pristine balance sheets. Stick with funds that focus on more creditworthy companies, such as those whose debt is rated BB -- just a couple of notches below "high quality" -- or above. One example: Pioneer Floating Rate (FLARX). Check a fund's credit quality at Morningstar.com.
Raise the credit quality of your munis. Battered municipal budgets will improve eventually, assuming the economy continues to heal. But historically, states and cities are among the last financial entities to emerge from a downturn. "I am not worried about credit risk among corporations, but I am worried about it in the muni space," says Envision Capital's Cohen.
To lower that risk, go with funds that invest mostly in municipal bonds rated AA or higher, like Fidelity Intermediate Municipal Income (FLTMX).
Lower the credit quality of your corporates. Move some of your corporate bond stash to high yielders. That's right: junk bonds.
This strategy isn't as crazy as it sounds. Junk bonds aren't as sensitive to rising rates as investment-grade bonds are, in part because their higher payouts provide a cushion if bond prices start to fall. In the past three periods when rates rose -- 2005, 1999, and 1994 -- high-yield bonds outperformed Treasuries by an average of 10 percentage points, according to an analysis by T. Rowe Price.
Moreover, if rates are rising because the economy is improving, demand for these bonds will climb. "A small positive change in the economy could have big changes in the fundamentals of these types of companies and their ability to pay back their debt," says Carl Kaufman, manager of the Osterweis Strategic Income fund.
That said, if investors fear the economy is headed into another storm -- as was the case in recent weeks -- high-yield funds could sink along with the broad stock market. In fact, the average high-yield fund has fallen nearly 4% over the past month (though it's still up more than 25% over the past year).
Given that the global economy hasn't fully recovered, stick with relatively conservative high-yield funds that avoid companies with the ugliest balance sheets. One such fund is Vanguard High-Yield Corporate (VWEHX). The typical bonds in this fund are issued by companies with ratings of BB or higher.
Don't give up on foreign bonds. The recent Greek tragedy may have you wondering if it's time to repatriate your entire fixed-income portfolio. Resist the urge.
As we've mentioned, Greece's debt problems have hurt the price of government bonds from Portugal and Spain. (Long-term Greek bonds now yield more than 8%, a reflection of how risky they are.) But those from many other European countries, including Germany and Britain -- whose government bonds yield almost exactly what U.S. Treasuries do -- have held up decently.
You should be looking beyond just Europe anyway. It's smart to diversify your fixed-income stake around the world because interest rates in different regions are expected to climb at different rates.
Another plus: If rates rise because of hotter inflation as expected, bonds from commodity-driven countries such as Australia, Brazil, and Canada will do well, says Thornburg's Brady. At the very least, they're highly unlikely to spoil your portfolio. To top of page
From CNNMONEY.COM Posted on June 04, 2010
Subscribe to:
Posts (Atom)