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By Jason Zweig and Joe Light
Feb. 21, 2014 6:28 p.m. ET
Are bonds a portfolio’s bulwark or its Achilles’ heel? Investors can’t seem to decide.
Over the last seven months of 2013, amid rising interest rates and falling bond prices, skittish investors yanked $18 billion more out of bond funds than they put in.
Then, as stocks faltered in the first six weeks of 2014, investors put in over $28 billion more to bond funds than they withdrew.
Adding to the confusion: Wednesday’s disclosure that Federal Reserve officials are debating whether to raise interest rates sooner than expected. The yield on the 10-year U.S. Treasury hit 2.75% on the news, up from 1.62% in May. (Bond yields move in the opposite direction of prices.)
After three decades of a mostly smooth and steady bond market, investors aren’t used to the recent volatility. That could be leading some to abandon their portfolios’ primary defenses right when they need them the most, experts say.
“Bonds are thought of as a safe haven, but even the safest harbors have waves,” says Martin Leibowitz, a managing director of research at Morgan Stanley and co-author of “Inside the Yield Book,” considered by investors to be one of the best books ever written on bonds.
Like all areas of investing, the bond market is rife with popular beliefs that are only partly true at best and misleading at worst. If you want to stop lurching from one wrong-footed bond trade to another, it pays to separate myth from reality.
Here is a guide to some of the most dangerous misinformation about investing in bonds and bond funds—along with practical steps you can take to invest wisely on the basis of more-accurate evidence.
Myth No. 1: Bond investors will suffer huge losses when interest rates rise.
Long-term U.S. Treasury bonds lost 12.7% last year as rates rose roughly one percentage point. And many Wall Street strategists expect rates to climb this year as the Fed changes course.
Yet losses on that scale across a wide variety of bonds are unlikely. To see why, you need a basic understanding of what pros call “duration.”
That measure—available from your fund’s website or, if you buy individual bonds, from your broker—shows the approximate percentage change in the price of a bond or bond fund for an immediate one-percentage-point move in interest rates.
The duration of the Barclays U.S. Aggregate Bond Index, the broadest benchmark for the fixed-income market, was around 5.6 years this past week. Thus, if rates rise one percentage point, the Barclays Aggregate would immediately fall in price by approximately 5.6%; a half-point rise would knock the index down in price by 2.8%, and so on.
“For big losses to occur, interest rates would have to rise enormously,” says Frank Fabozzi, a bond expert who teaches finance at EDHEC Business School in Paris and Princeton University.
To incur a 20% loss on a bond fund with a duration of 5.6 years, for instance, interest rates would have to rise instantaneously by approximately four percentage points. Even a 10% loss would require an immediate—and historically unprecedented—jump in rates of roughly two points. (Long-term U.S. Treasurys have a duration of more than 16 years, which is why they are so sensitive to rising rates.)
At today’s low rates, “you should have lower expectations for total return and yield, but the extent of the potential negative returns has been exaggerated,” says Matthew Tucker, head of fixed-income strategy at BlackRock’s iShares unit, the largest manager of exchange-traded funds.
That is because, as rates rise, you get to invest the income thrown off by your old bonds at the new, higher yields. As a bond investor, your total return is the sum of any price changes and the income the bonds produce.
Imagine that interest rates rise by a quarter of a percentage point. That would immediately knock about 1.4% off the price of a bond fund with a duration of 5.6 years. But it also would add a quarter-point to the yield of fresh bonds coming into the portfolio, making up over the longer term for the short-term decline in price.
In recently published research, Morgan Stanley’s Mr. Leibowitz has shown that so long as a fund (or even a “ladder” of individual bonds assembled to mature at equally spaced intervals of time) maintains a moderate, five-to-six-year duration, the portfolio’s annual total return should converge toward its original yield. That assumes that you hold the fund or ladder at least six years.
Remarkably, he found that outcome will occur under almost all possible scenarios, regardless of how much interest rates change.
As a result, Mr. Leibowitz says, “if you are determinedly a long-term investor, you can get through a period of intervening turbulence” comfortable in the knowledge that any losses in market value will be offset over time by the extra income from higher rates.
All this points toward a simple strategy: Ignore the harum-scarum rhetoric about a bond-market bloodbath. For government and investment-grade corporate bonds and bond funds with a duration less than 10 years, that scenario is just a myth.
So long as you keep your duration short—and stick with high-quality bonds—you should be in no danger of anything greater than a temporary, single-digit loss.
Ask yourself what is the worst loss you are willing to withstand on your bond investments for each one-percentage-point rise in interest rates. If that maximum loss is 5%, then you want a bond or bond fund with a duration of five years, slightly shorter than that of the Barclays Aggregate. (The average intermediate-term bond fund, according to Chicago-based investment researcher Morningstar, has a duration of 4.9 years.)
You can get higher yield than the current 2.3% offered by the Barclays Aggregate Index—but only if you are comfortable with higher duration. The Vanguard Long-Term Corporate Bond ETF, for instance, yields 5%, but its duration is 13.4 years—meaning that a quarter-point rise in rates would trigger a 3.4% short-term decline in price.
Myth No. 2: Investors who need income must own “bond alternatives.”
These alternatives include real-estate investment trusts, master limited partnerships, preferred stock, dividend-paying common stock, business-development companies and bank loans.
“None of these things are substitutes for the safest bonds,” says Larry Swedroe, director of research at the BAM Alliance, a nationwide group of investment advisers based in St. Louis. Some of these assets, like REITs and MLPs, “have good diversification characteristics and can play a role in a diversified portfolio,” he says. The other popular bond alternatives, he warns, provide extra income in good times—but won’t act like bonds during bad times.
While recessions are bad for stocks, they are good for bonds. In 2008, U.S. Treasurys were the only major asset that went up in price. Everything else collapsed in the financial crisis—including these bond alternatives, which are highly sensitive to economic downturns.
In 2008, for instance, bank loans lost 28%. In the fourth quarter of 2008 alone, REITs lost 40%, MLPs 20% and high-yield bonds 18%, says Mr. Swedroe, even as five-year U.S. Treasurys rose 7.5%.
“When you get a bear market in stocks,” he says, “many of these things act like stocks, too.” As a result, “you have a much bigger loss in your overall portfolio” than you would have if you had stuck to government bonds.
“There’s one thing that never really gets talked about in the discussion about ‘bond alternatives,'” says Fran Kinniry, an investment strategist at financial-services giant Vanguard Group. “If someone is offering you a higher yield, you have to expect your risk to go up by the same proportion.”
Instead of taking on more risk in the pursuit of more income, consider a technique for reducing your risk and raising your income at the same time.
You can generate higher income from your existing portfolio by selling off small slivers of your stocks or stock funds in regular increments. This way, “you can manufacture homemade dividends,” Mr. Swedroe says. Work with your accountant to sell the shares that cost you the most first; that will minimize your capital-gains tax bill.
The next time someone tries to sell you on the virtues of “bond alternatives,” just remember that an investment is either a bond or it isn’t. And if it isn’t, then it either belongs somewhere else in your portfolio, or nowhere at all.
Myth No. 3: Municipal bonds and funds are safe diversifiers for a stock portfolio.
When it comes to municipal bonds, think nationally, not locally.
Single-state municipal-bond mutual funds hold more than $148 billion in assets, according to Morningstar.
But bonds issued in your home state, as well as the funds that hold them, can harbor risks that might offset some of their tax advantages.
For starters, your job, the value of your home and even the quality of your children’s schools can depend on the health of your local economy.
If you lose your job in the midst of a local housing slump, the value of municipal bonds issued nearby isn’t likely to tide you over. As Detroit’s recent difficulties show, just when you would most like your municipal bonds to hold their value, they may be suffering as severely as your job security and your home value.
Furthermore, many municipalities are counting on investment returns of 7% or more to help them fund future benefits for public employees. If the stock market performs poorly in the future, such municipalities could have to cut benefits, raise taxes or take on more risk to fund their commitments.
Therefore, says Allan Roth, a financial adviser at Wealth Logic, a firm in Colorado Springs, Colo., “if stocks don’t have a gangbuster decade, there’s going to be a lot of stress on the ability of municipalities to meet their obligations.”
That, in turn, creates an implicit link between the riskiness of stocks and municipal bonds, Mr. Roth says. As a result, he says, you should diversify your muni holdings nationwide, rather than concentrating them in your home state. And bear in mind that municipals make up approximately 10% of the total U.S. bond market. Many investors use munis for 90% or more of their bond exposure, Mr. Roth says; he advises that anything over about 30% is excessive.
Minimize your exposure to single-state funds and to expensive closed-end funds that use “leverage,” or borrowed money, to buy munis. Stick to low-cost, intermediate-term national funds that hold munis from a variety of states, like the Vanguard Intermediate-Term Tax-Exempt mutual fund or the iShares National AMT-Free Muni Bond ETF, which charge 0.20% and 0.25% in annual expenses, respectively, or $20 and $25 on a $10,000 investment.
Myth No. 4: Actively managed “go anywhere” funds will outperform in a bad market.
Mutual-fund companies have lately been hawking a purported antidote to rising rates: so-called go-anywhere bond funds.
Also called “nontraditional” or “unconstrained” funds, go-anywhere funds invest, well, just about anywhere, including in bonds in the U.S. or abroad, floating-rate bank loans and sometimes even stocks.
The idea: By roving far and wide, an active bond manager can limit the pain investors will feel as interest rates rise.
The pitch is working. Last year, investors poured a net $55.3 billion into nontraditional bond funds, according to Morningstar, more than they did from 2010 through 2012.
But the more nontraditional a fund gets, the more investors might be blindsided when their investment doesn’t act anything like what they have come to expect from bonds, says Morningstar senior analyst Eric Jacobson.
Go-anywhere funds, the majority of which launched in the past couple of years, also haven’t yet proved that they can deliver on their promises. In the past 12 months through Thursday, nontraditional bond funds have lost 0.2% on average, while the Barclays Aggregate index has been flat. In the last three years, go-anywhere funds have risen 2.4%, an annual average of 1.4 percentage points less than the index.
Of course, some funds have fared better.
The Goldman Sachs Strategic Income Fund, whose “A” shares have an expense ratio of 0.99%, has returned 4.8% annually over the past three years. Portfolio manager Michael Swell says that the fund has succeeded with a strategy that isn’t tied to the fate of interest rates.
While bonds have stagnated, Mr. Swell has made money by using options to give his portfolio a duration of negative two years. Unlike the typical bond fund, Mr. Swell’s fund should go up—not down—if interest rates climb.
However, if the stock market tanks while the fund’s duration is negative, falling interest rates could punish Mr. Swell’s fund even as a traditional bond fund will benefit—a potential risk that he doesn’t deny. Mr. Swell says he doesn’t recommend that investors put more than half of their fixed-income allocation into unconstrained funds.
For many people, even that much might be too much. Says Mr. Jacobson: “When you replace your conventional bond holdings with [go-anywhere funds], you are giving up a very, very valuable piece of insurance in your portfolio.”
Myth No. 5: Individual bonds are better than bond funds.
Many investors worrying about the risk of rising interest rates prefer to hold individual bonds. This way, they figure, they are assured of getting 100% of their principal back so long as they hold to maturity—with no risk of suffering interim losses in market value.
It is true that if you hold a given bond until it matures, you will receive 100 cents back on the dollar (ignoring inflation and the possibility of default). It also is true that mutual funds and ETFs generally don’t have a fixed maturity date and will therefore fall in price whenever interest rates rise.
But your individual bond also falls in value when rates rise; you just don’t see it, since you aren’t repricing it daily. If you did have to sell it on the open market, it would drop in price by the same proportion as a bond fund with similar sensitivity to interest rates. But only the fund will reflect that change in its daily price. So the bond isn’t safer than the bond fund; that is an illusion.
Individual bonds have at least one disadvantage compared with funds: what Mr. Kinniry of Vanguard calls “cash drag.”
Imagine that you own a $10,000 corporate bond paying 4% annual interest in two equal payments a year. Every six months, the bond generates $200 in interest income. Bonds aren’t available in such small denominations, so most likely you will deposit the income in a bank account earning less than 1%.
In a fund that yields 4%, however, you can reinvest your income into more bonds earning 4%—and if interest rates rise, those reinvestments will buy new bonds at even higher rates.
Given today’s paltry returns on cash, a bond fund yielding 4% will generate greater total income over time than an individual bond yielding 4%, because of the power of interest-on-interest.
Bond funds, which typically hold hundreds of securities and can trade them cheaply, also offer better diversification and lower trading costs than most investors are likely to be able to get on an individual bond.
Therefore, Mr. Kinniry says, unless you have roughly $10 million or more, bond funds are a better deal. Just make sure you keep your ownership costs at rock-bottom. If you are paying more than about 0.5% in annual expenses, you probably are overpaying.
In a low-interest-rate world, the last thing you want to do is to pay high fees.
Source: The Wall Street Journal