Escalating sovereign debt problems in Europe plus the recent weak U.S. employment reports have raised fears that we could be headed into recession again.
When selecting bond funds, you have to consider risk; specifically historical volatility and the future risk that the bonds held by a fund might default.
The best historical volatility gauge has a scary name: “standard deviation.” Despite the name, the concept is simple. Standard deviation measures how much a fund’s share has price bounced around in the past, regardless of whether in the end, it moved up, down, or sideways. That’s important if for no other reason than it’sthose nasty price swings that keep you up nights, and incite you to bail out just when the fund has touched bottom.
Although, far from perfect, bond credit ratings from agencies such as Standard & Poor’s and Moody’s are the best tools we have for evaluating the chances that a company might sometime in the future default on its bond payments. Bond raters use a combination of letters, numbers, and plus or minus signs to express their ratings. The specific format varies between ratings services but “AAA” always indicates the highest quality rating, and any rating starting with “A” signifies reasonably high quality debt. Three letter ratings starting with “B” such as BAA or BBB indicate lower quality debt than “A” ratings, but are still considered investment quality. One or two letter “B” ratings and anything starting with a “C” is considered below investment quality. Thus, for this strategy, funds with significant holdings should be avoided.
Vanguard, an ETF, tracks an index that represents a wide variety of medium-term government, government percent on average annually with a 4.3 standard deviation. Its 3.2% estimated annual dividend yield (next 12-month’s dividends divided by share price) won’t knock your socks off, but it beats what banks are paying. Considering the low volatility, solid credit ratings, and diversity of its holdings, Vanguard Total Bond is about as close as you can get to a bank account replacement. However, unlike bank accounts, it’s not insured by the U.S. government.
AllianceBernstein is a closed-end fund. About 65% of its assets are invested in securities issued by the U.S. government or its agencies. AB invests the balance in U.S. corporate and foreign government debt securities. As of August 31, 71% of its assets were AAA rated debt. AB Income has returned 6% on average, annually, over the past three years with an 8.6 standard deviation. Its expected annual dividend yield is 6.0%.
The fund, an ETF, holds investment grade bonds issued by corporations, mostly issued by U.S.-based corporations. Unlike AllianceBernstein that focuses on AAA rated bonds, iShares holds mostly A and BBB rated bonds, which are at the lower end of the investment grade range. Even so, the standard deviation is a relatively low 10.7. The fund has averaged a 6% return, on average, annually, over the past three years. It pays a 4.6% expected dividend yield.
Hancock, a closed-end fund with a 20.8 standard deviation, is, on the surface at least, the riskiest fund of the group. But, in this instance, the standard deviation is misleading. Here’s why.