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The Bond Market Conundrum of 2011 — Part II

Posted on December 22, 2010 | Leave a comment

Portfolio Management Preferences to Reduce Risk

LOOK BEYOND TREASURIES

U.S. investors have easy and relatively inexpensive access to a broader selection of bonds than they had in 1994.

  • Non-U.S. bonds provide U.S. investors access to different economic cycles, interest rates and currency values which can help reduce overall portfolio risk.
  • Floating rate bank loans are another portion of the bond market that actually do better in rising interest rate environments. These loans are very short term, resetting every 30-90 days.

High-yield corporate bonds (those below investment grade ratings) have historically performed much better than other bonds during periods of increasing interest rates.

Consider this research reported by Investment News writer Jeff Benjamin:

According to an analysis of the biggest interest rate moves over the 20-year period through June 2006, high-yield bonds are remarkably resilient against interest rate volatility. Between September 1987 and June 2006, there were six separate 12-month periods that saw the yield on the 10-year Treasury climb by between 117 and 222 basis points. The average total return of high-yield bonds for those same 12-month periods was 5.5%, with just one negative-return period.

THE TOUGHEST DECISION

If your investment mix currently includes a significant overweight to stocks, should you leave it that way or diversify to include bonds at a point when bond returns are not expected to be nearly as good as they have been over the past few decades?

While the potential to see the value of your bond holdings drop is discouraging, watching them decline perhaps a few percent should be much more palatable than watching a stock investment decline significantly more.

If global economic conditions receive any more shocks, it’s conceivable that U.S. and international stocks could return to a bear market, declining 20% or more. In this case, having some bond exposure creates downside protection in a broadly diversified investment mix. It may be a hollow victory for bonds if all they do is lose less, but their ability to steady a portfolio amid periods of stock volatility can be valuable.

Let’s not forget that since March 9, 2009, the U.S. stock market has been on an exceptional run. The S&P 500 Index gained 85.5% as of December 22. Small companies, as measured by the Russell 2000 Index gained 130.3%. A correction would not be surprising.

WHAT ABOUT MUNICIPAL BONDS?

The biggest fear in the municipal bond market isn’t so much interest rates as it is pure default by the municipality. Clearly, government entities at all levels are faced with significant deficits. Historically, municipal bond default rates have been very low, essentially not a concern expect in a few high profile cases (Orange County, CA, the WPPSS nuclear project here in Washington). Holding a diversified mix of many different types of municipal bonds can minimize default risk.

Many people assume that if cities or other municipal entities fail, the Federal Reserve will bail them out, saving value for bond holders. This could be the case but may serve to further bog down the economy.

Even if we see 50-100 imminent municipal defaults as Meredith Whitney forecast on 60 Minutes December 19, that is a small percentage of the overall municipal bond market. If your municipal bond exposure is in an actively managed mutual fund with an experienced analyst monitoring credit ratings, the default impact may not be all that significant.

IS CASH A BETTER BET?

Shifting the fixed income portion of your investment mix to cash comes with an opportunity cost. What if interest rates don’t move quickly and bonds continue to produce attractive total returns? What if U.S. interest rates increase slowly and bond returns decline moderately?

If your current bond holdings are in a portion of your portfolio that can’t take even a minor loss in the next two years, we think that this investment should be in cash. If you can afford to take a limited amount of risk, we think that concerns about bond declines may be overstated from a longer-term perspective. More importantly, cash holdings do not rally.

EXPECTATIONS ARE BUILT INTO MARKET PRICES

All investment markets are driven by future expectations. These expectations are already priced into stocks and bonds. Bond investors don’t generally expect the same tailwind that has filled their sails for most of the past generation. A less friendly headwind may already be evident in the price of bond funds.

WHY WE PREFER BOND MUTUAL FUNDS OVER INDIVIDUAL ISSUES

We feel more comfortable letting professional bond managers navigate the opportunity and pitfalls the market presents.  Bond fund managers spend their days building portfolios that are liquid, sensitive to the outlook for interest rates, and focused on managing the risks and returns for their investors.  Unless you are certain as an individual investor that you will hold individual bonds until they mature, receiving a payout of the bond’s face value, and that you have enough individual bonds to diversify away as many of the risks as possible, it is unlikely you will be able to outperform these professional  managers on an ongoing basis.

Considering the open issues and historical precedent, investors definitely need to ratchet down expectations for U.S. bond returns. But we don’t think you need to run away from U.S. bonds altogether. And your portfolio may be optimized by expanding to include international bonds.

Part I What Happens When Interest Rates Rise

~ Gary Brooks, CFP®, Allyn Hughes, CFP®, and Nancy Jones, CFP®, — Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA

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The Bond Market Conundrum of 2011 — Part I

Posted on December 22, 2010 | Leave a comment

What Happens When Interest Rates Rise

Given historically low U.S. interest rates, government stimulus efforts that seem likely to spark inflation and a massive flow of cash chasing returns, many investors think that it is not an ideal time to invest in U.S. bonds.

But does that mean that investors should move away from existing U.S. bonds holdings or avoid investing any new money in bonds?

U.S. bonds are not a compelling investment currently for a few reasons:

  • A very long bull market for bonds is running out of support from fundamental market factors that drive value
  • Massive cash inflow has flooded bond markets with buyers, driving prices up
  • Interest rates have nowhere to go but up, hurting bond prices

The interest rate concern seems to be the biggest, especially for investors who remember 1994 when many U.S. bond mutual funds lost money even after considering the income their bonds paid out.

Compounding the lack of clarity is the uncertainty of actual increases in interest rates. Bill Gross, manager of the PIMCO Total Return Fund, the largest bond mutual fund in the world, believes that the Federal Reserve will not be faced with a need to raise interest rates for at least another year, potentially well in to 2012. He is not alone in this assumption.

There’s also no telling how fast rates will rise once the economy seems healthy on its own unstimulated merits. Gross is far more worried about the economy and its impact on the U.S. stock and bond markets than he is on interest rate changes. Unemployment will have to come down and inflation will have to be more obvious before there is pressure to raise rates. If the recovery continues to be a jobless one, we could continue in our low interest rate environment for a long time.

It’s possible that short-term interest rates and long-term rates could take different paths. The Federal Reserve manipulates the economy and markets to influence short-term interest rates but the market itself has more influence on long-term interest rates.

Past bond market performance gives us an indication of what returns we may expect when interest rates rise (causing the value of many types of bonds to fall). The trouble is that previous cycles of climbing interest rates weren’t also paired with unemployment, deficits, an economy boosted by artificial stimulus, and political combativeness, all at the same time.

A REMINDER THAT BONDS CAN LOSE VALUE

In 1994, many investors thought that bonds would protect them from loss. This is true if you own individual bonds and hold them to maturity, collecting coupon payments along the way and retrieving the principal of the bond at maturity. But if you have to sell your bonds or the bond mutual fund you own sells bonds, they could be sold for less than their purchase price.

In February 1994, U.S. interest rates began a relatively swift climb. They increased from 3.0% to 6.0% in one year. In that time, the Vanguard Total Bond Market Index Fund had a total return of -1.51%. Declines in the price of the fund outweighed income paid out by the fund for a full year.

We don’t think that it is likely that once interest rates do begin to climb, that they will increase 3% in a year, but it is still a possible scenario.

A MORE LIKELY INCREASING RATES SCENARIO

It was just a few years ago that interest rates reached their most recent peak. In July 2004, interest rates climbed from 1.0% to 1.25%. They continued to climb until September 2007 when they peaked at 5.25%.

Bond mutual funds fared much better in this period than during 1994:

Fund Cumulative Total Return (income + price appreciation) from July 1, 2004 – Sept. 4, 2007
Barclays Aggregate Bond Index ETF 13.5%
Vanguard Total Bond Market Index Fund 14.19
Vanguard Long-Term Bond Market Index Fund 18.80
Vanguard Short-Term Bond Market Index Fund 11.69
iShares 1-3 year Treasury Bond ETF 11.03
PIMCO Total Return 16.44
Fidelity Strategic Income 25.99
Templeton Global Bond 39.36
Vanguard Total U.S. Stock Market Index Fund 42.41

This was not a period of exceptional bond returns. If you divide the cumulative total returns by three you get a rough annualized return. There were some reasonably good returns, particularly for non-Treasury bonds. Foreign bonds and corporate bonds in general that were not punished by the increasing interest rate environment.

Let’s take a closer look at the experience of the PIMCO Total Return Fund, managed by Gross. From July 1, 2004 through September 4, 2007, the fund had a price return of -2.24% but a total return of 16.44%.

If you invested $10,000 in this Fund, just as interest rates began to climb in July 2004 and reinvested dividends over the three years, the fund paid out $1,831.52. The negative price impact left the investment’s value at $11,605.72 on Sept. 4, 2007. While the total return is not significant, it did continue to outpace inflation. Reinvesting dividends also added 174 shares to the holding over the period, increasing future growth.

Certainly there are differences between our economic situation today and the previous two climbing-interest rate environments. We are coming out of a deeper recession and the market will have to deal with the impact of massive cash stimulus (quantitative easing) that was not a consideration in 1994 or 2004-07.

If we rewind the calendar for a full generation, back to 1973, we can see how the U.S. bond market performed in a wide variety of economic conditions, market expectations, and political changes.

In the 37 years since then, the Barclays U.S. Aggregate Bond Index has had a negative return over a calendar year three times (-2.91% in 1974, -2.92% in 1994 and -0.82% in 1999). The 37-year average annual return was 8.22%.

Part II Portfolio Management Preferences to Reduce Risk

Past performance does not guarantee future results.

~ Gary Brooks, CFP®, Allyn Hughes, CFP®, and Nancy Jones, CFP®, — Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA

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