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

June 24, 2010, 12:08 PM EDT

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