FEBRUARY 11, 2012
Article from The Wall Street Journal
By BEN LEVISOHN
Many investors, looking for better returns and a little safety, are loading up on corporate bonds, which have been far steadier than stocks during the market storms of the past few years.
But corporate bonds are getting less safe by the day.
A change in the way corporate bonds are traded is resulting in murkier prices, more volatility and less differentiation among individual bonds. The result: Experts say investors should expect more risk and potentially less return from such bonds in the future, and rethink how they assemble their entire bond portfolios.
The good news? Once investors understand how the corporate-bond market is changing, they can make educated decisions about which kinds of investments—mutual funds, exchange-traded funds or individual bonds—make the most sense, given their investing goals.
"The changes will ultimately hurt the small investor," says Howard Simons, strategist at Bianco Research. "The only thing you can do is be aware of how risk has shifted and act accordingly."
It is easy to be complacent about an investment when it is surging. A broad rally in Treasury securities is pushing up prices of all manner of other bonds. After a strong 2011, relatively safe corporate bonds rated "investment grade" by the bond-rating firms have returned 1.9% this year—their best annual start since 2001. Riskier high-yield, or "junk," bonds have returned 4.1%. This, after three decades of steadily rising bond prices—among the longest bull markets for bonds in history.
Since the Federal Reserve's announcement late last month that it expects to keep interest rates low through 2014, investors have stepped up their buying even more. During the week ended Feb. 1, investors poured $7.5 billion into bond mutual funds, the most since data firm EPFR Global began tracking such investments in 2002.
Most advisers recommend that investors hold a broad mix of Treasurys and corporate bonds. But while the Treasury market continues to be the biggest and deepest investment market in the world, corporate bonds are becoming less predictable, even for the pros.
Banks Step Back
At the heart of the shift is the declining role of banks, which historically have been big corporate bond dealers, keeping vast reserves of bonds on their books and matching buyers and sellers. Experts say new regulations, including the Dodd-Frank Act, the so-called Volcker rule, which bans banks from trading for their own account, and Basel III, which governs banks internationally, have forced banks to be more selective about what they hold.
All told, banks hold about $45 billion in corporate bonds with maturities over one year, versus about $215 billion at the beginning of 2008, according to Barclays Capital.
Mutual funds, exchange-traded funds and other investors are filling the void. Investment-grade and high-yield corporate-bond funds have doubled in size since the beginning of 2008, to $1.2 trillion and almost $250 billion, respectively, according to Barclays. In the $1 trillion high-yield bond market, ETFs now account for about 3% of the market, up from virtually nothing four years ago.
As the steadying influence of banks wanes, the bond market is more vulnerable to swings in investor sentiment, experts say.
Prices today are being driven more by the whims of investors buying and selling funds and ETFs and less by the fundamentals of the bonds themselves, says Mr. Simons of Bianco Research. Investment-grade bonds have seen their volatility nearly triple during the past three years, compared with the three years before the financial crisis, according to Barclays Capital. High-yield bonds are more than twice as volatile.
The result is bigger opportunities for gains when the market goes up—but a bigger chance of losses when the market tanks, says David Sherman, principal at Cohanzick Management and portfolio manager of the RiverPark Short-Term High-Yield fund.
Murkier Prices
Making matters trickier for investors, bond prices are artificially high because of the Fed's recent rounds of Treasury purchases, which have pushed up the prices of most other bonds as investors seek higher yields. That makes traditional investment gauges less useful.
Consider the debate about whether junk bonds are a good investment now. One way managers value bonds is to look at the difference between their yields and those of Treasurys. When the gap is wider than the historical average, many managers say corporate bonds represent a good value. That seems to be the case now: The "spread" between high-yield corporate bonds and Treasurys is about 6.4 percentage points, above the 15-year average of 6.
Not so fast, others say. Because Treasury rates are artificially low, it is better to use the actual yield of the high-yield bond index, which currently is 7.3%, far below the 15-year average of 10%.
On that basis, the skeptics say, the bond yields aren't enough to compensate investors for the risks they are taking.
If you aren't sure you can value a bond, "you don't want to get involved," says Stephen Antczak, head of U.S. credit strategy at Citigroup.
Trouble for Funds
The changes in the market are forcing mutual-fund managers to rethink their strategies in ways that could dent returns and increase risk for investors.
Funds are required to allow shareholders to buy new shares or withdraw all of their cash every trading day. But the increased volatility is forcing managers to be more careful with their portfolios.
"Investors pulling out a lot of money in a hurry can upend an investment strategy and force you to sell things you don't necessarily want to sell," says Eric Jacobson, director of fixed-income research at Morningstar.
Many managers are choosing to hold more "liquid" bonds, which can be sold at a moment's notice. Bob Brown, president of the bond group at Fidelity Investments, says the firm now looks only for highly liquid securities. Eaton Vance has reduced the amount of hard-to-sell securities it owns in its portfolios.
The problem is that liquid bonds typically are more volatile than illiquid ones because they trade more frequently. The Barclays Very Liquid High Yield Bond Index is 25% more volatile than the Barclays High-Yield Bond index, which contains a mixture of liquid and less-liquid securities.
The price for liquidity, in other words, is more violent swings.
Some managers are boosting their cash holdings, which can reduce returns, so that they will have enough money on hand to meet redemptions quickly if the market drops and investors start selling. The Eaton Vance Income Fund of Boston, for example, now holds about 5% to 6% of its portfolio in cash, versus 2% before the financial crisis.
"Do you hold more cash, more liquid bonds or some balance of those two?" asks Jeff Meli, a strategist at Barclays Capital.
Playing the Market
So what is an individual investor to do?
Experts say people who can afford to do so should stick with individual bonds. Typically corporate bonds have a face value of $1,000, but investors should plan on buying blocks of at least $20,000 to avoid getting hit hard by commissions. Advisers generally recommend investors buy bonds from at least 20 different issuers, for diversification.
Since most investors buy bonds for income and plan to hold them to maturity, they don't have to worry as much about the market's volatility or increased correlation. They also can buy cheaper illiquid bonds that fund managers avoid.
There are downsides, however. Institutions tend to get better prices for big blocks of bonds than small investors can get for smaller blocks. Investors should check the Financial Industry Regulatory Authority's Trade Reporting and Compliance Engine website, known as Trace, to find recent prices. And these days, getting your hands on bonds with decent yields isn't easy, because investors are holding on to them rather than selling them for profit, says Marilyn Cohen, president of Envision Capital Management in Los Angeles.
Experts suggest investors look for companies with good cash flows and improving profitability. Ms. Cohen recommends three that she says fit the bill: a high-yield bond issued by auto-parts maker American Axle that matures in 2017 and has a 6.33% yield. She also likes a high-yield issue by energy-company Chesapeake Energy maturing in 2020 with a 6.38% yield, and an investment-grade bond from auto-parts maker BorgWarner that matures in 2020 and yields 3.51%. (Investment-grade bonds carry ratings of triple-B or higher from Standard & Poor's and Fitch Ratings and Baa or higher from Moody's; high-yield bonds have lower ratings.)
Fund Choices
Many investors can't afford individual bonds or don't have access to them in 401(k) accounts. For them, funds and ETFs are the only alternative.
They, like professional fund managers, must decide whether to look for more liquidity or less, and more cash or less.
Such investors should think about what they are trying to achieve with their bond holdings. For instance, an investor who wants exposure to the entire asset class should choose a fund or ETF with a low expense ratio and little cash, says Warren Ward of financial-advisory firm Warren Ward Associates.
"We choose from the lowest-cost funds available," he says. "And we prefer to make the cash decision ourselves."
Michael Gibney, an adviser at Highland Financial Advisors in Riverdale, N.J., recommends holding a large fund like the $16.2 billion Vanguard Intermediate-Term Investment Grade fund, a portfolio of 1,218 bonds that carries an expense ratio of 0.22%.
Sarah Bush, a senior fund analyst at Morningstar, suggests the $15.6 billion Vanguard High-Yield Corporate fund, which has an expense ratio of 0.25% and has just 1.6% in cash.
Other options include the $18.7 billion iBoxx Investment-Grade Corporate Bond ETF, which has an expense ratio of 0.15%, and the $13.4 billion iShares iBoxx High-Yield Corporate Bond ETF, which charges 0.5% in fees.
Sam Katzman, chief investment officer at Constellation Wealth Advisors in New York, prefers "go-anywhere" funds that have wider latitude in the types of bonds they buy and the amount of cash they hold. Such funds are for investors who prefer their manager make decisions about whether they think the bond market looks rich or cheap and act accordingly.
Mr. Katzman likes the $60 billion Templeton Global Bond fund, which owns international bonds and currencies as well as U.S. corporate bonds, and has an expense ratio of 0.88%.
Not everyone thinks cash is bad. Gregory Lavine, an adviser at Altfest Personal Wealth Management in New York, says he isn't concerned by managers holding some when better opportunities are unavailable. One of his choices: the Loomis Sayles Bond fund, which has about 11% in cash and an expense ratio of 0.63%.
Cash doesn't have to subtract too much from performance. The ING Pimco High-Yield Portfolio has an 8.7% cash stake, well above the category average of 5.9%, yet has been in the top 25% of high yield funds during the past one and three years, according to Morningstar.
Says Mr. Lavine: "It's better to hold cash than invest poorly."
Article from The Wall Street Journal