Some decent basics pertaining to bonds...
valueline.com
The Value Line Mutual Fund Survey
Published June 27, 2006
The Long and the Short of it
In recent years, the bond market has been a far more interesting place to invest than is generally thought. In fact, during the market downdraft that started in 2000, bonds were a great place to be and, in many cases, make some good money.
Bonds did well in this period because the Federal Reserve, under former head Alan Greenspan, lowered short-term interest rates in an attempt to boost economic growth, the goal being to keep any recession short and shallow.
Bond prices and yields move in opposite directions, so as yields fell, bond prices went up—dramatically in some areas of the market. This occurs because when most bonds are sold, the amount of interest they pay is set and does not change. So, if the face value of a bond is $1,000 and it pays, for simplicity sake, $100 in interest, the yield would be 10%. It would only sell at this yield if it was the market-demanded yield. So, it is safe to assume that, at the time of sale, that was the going interest rate.
If the interest-rate environment changed and investors were demanding a higher yield, say 11%, then the above $1,000 bond wouldn't be competitive with its $100 payout. The only way to change the yield from 10% to 11%, since the payout is set, is for the price of the bond to fluctuate in the secondary market. If the bonds trade hands at closer to $900, the $100 payout would, based on the price of the bond, equate to the market demanded yield.
On the flip side, if the rate demanded by the market dropped to 9%, a $1,000 bond paying out $100 in interest would be worth more. The price would, thus, increase to about $1,100 so that, based on the $100 interest payment, the bond would yield the market rate.
This is an often-confusing dynamic in the bond world. The only way to avoid this is to buy an individual bond and hold it to maturity. This can be cumbersome and expensive, so bond funds are usually the best option for individual investors. The problem is that most bond funds have the goal of total return, so the managers often trade on a frequent basis—taking advantage of and being hurt by changes in interest rates.
Another important part of this puzzle is the difference between the rates on bonds that mature in a short period of time and those that mature at a far-out date. Bonds that mature relatively soon aren't as affected by rate swings as much as longer-dated bonds because there is less risk to principal loss (the value of the bond) due to rate changes.
The difference between yields based on maturity dates creates what is called the yield curve. In most situations, the yield curve slopes upward, with longer-dated bonds yielding more than shorter-dated, less interest-rate sensitive bonds.
The current environment is something of an anomaly. After a long period in which rates were falling and bond prices rising, the specter of inflation sparked the Fed to start increasing rates. The normal expectation would have been for rates on longer-dated bonds to move up as the market prices of the bonds fell. This did not happen to the degree expected.
With short-term rates rising in tandem with the Fed's rate increases, however, there was a flattening in the yield curve. Thus, investors were being paid a similar amount to own short-term paper and long-term paper. In short, both risky and less risky bonds were providing about the same return.
In fact, the yield curve has even inverted a couple of times, so that long-term bonds were yielding less than short-term bonds. This could be read to indicate that the short-term risks in the economy were greater than the long-term risks, so short-term bonds had to yield more than long-term bonds to compensate for the risk. This is not the norm, and yield curve inversions have, historically, preceded recessions.
While I'm not smart enough to predict recessions, and I don't know anyone who is smart enough to do that, I know that a flat or inverted yield curve isn't normal. Most things in the world, including financial markets, tend to revert to the mean. I'm fairly confident (read that as "certain") that this will take place in the bond market. I don't know when, but I do know it will happen.
I've been concerned about the flat yield curve for over a year and, with a second yield curve inversion having taken place, I am even more concerned right now. What I've been telling investors to do is buy shortterm bond funds. The logic being that if you can get almost the same yield as more volatile long-term bonds, why take on the extra risk of owning the long-term bonds?
The fund I've most often suggested is Vanguard Short-Term Bond Index Fund (VBISX), a fund I own myself. This is a great fund that doesn't require much watching because it will always be at the short end of the yield curve and, as an index fund, will track the market. Fidelity and T. Rowe Price both have decent short-term bond funds, too.
On that note, active management of a bond fund with a short-term focus can only add just so much to performance, as quality is the main factor under management's control. Indeed, in most cases, the performance difference between funds that target specific quality and/or yield curve segments will be based on a fund's expenses. Funds that can shift up and down the yield curve and/or the quality spectrum, however, will benefit more from active management. Of course, allowing management to do as it pleases also increases the risk that mistakes will be made.
One of the few actively managed funds that I recommend is Dodge & Cox Income Fund (DODIX). This fund's objective is a high and stable rate of current income, consistent with the long-term preservation of capital. It also has the secondary objective of capital appreciation.
To achieve these goals, management invests the majority of the fund's assets in a diversified portfolio of high-quality bonds, including U.S. government obligations, mortgage and asset-backed securities, corporate bonds, collateralized mortgage obligations, and other debt rated A or better by either the major bond rating agencies. It may, however, invest in lower-rated debt.
Management's view of the economy, the relative yields of securities in different market sectors, and the investment prospects of the issuing companies will dictate the structure of the portfolio. In selecting individual securities, management considers factors including yield-to-maturity, quality, liquidity, call risk, current yield, and capital appreciation potential.
Essentially, the fund can go just about anywhere and do just about anything. That said, it has a stellar long-term track record and is backed by a relatively small company that boasts a great history. It is definitely worth consideration if you are looking for an actively managed bond fund. Moreover, management has limited its exposure to rising rates by keeping to the short end of the yield curve.
What happens to interest rates from here is anybody's guess. Value Line expects at least one more short-term interest rate hike by the Federal Reserve, now under the guiding hand of Ben Bernanke. If the new Fed Chairman raises rates too much, which some suggest he already has, we could see a material economic slowdown. If he doesn't increase enough, inflation could move higher than it already has. More difficult to figure out, however, is the market's reaction to Bernanke's comments, which don't yet inspire the confidence of Greenspan's words.
When all is said and done, I suggest avoiding risk as much as possible and buying a high-quality short-term bond index fund.
Reuben Gregg Brewer
Editor
EK!!! |
