Fear Higher Rates? Buy Individual Bonds Instead of Bond Funds

by: Bondsquawk, CFA

By Rom Bidilla

As we have discussed, bonds have outperformed stocks not only in 2010 but also on a longer term basis. For 2010, Bonds as represented by the Merrill Lynch U.S. Corporate Index and the U.S. Treasury Index gained 6.1 percent and 5.9 percent, respectively. Comparatively, equities, as measured by the S&P 500, have lost 7.6 percent for the year.

Over a longer period of time, the picture doesn’t really change much. Trailing five-year performance for stocks stands at a total return loss of 13.5 percent while corporate and Treasuries gained 28.6 percent and 30.2 percent, respectively, over the same time frame. To rub salt on the wound for stocks, even the high yield sector aka “junk bonds” outperformed its equity counterpart. The Merrill Lynch High Yield Master Index gained 40 percent in the past five years. Keep in mind that this impressive gain includes a period where spreads reached astronomical levels and well into the triple digits during the height of the financial crisis and recession.

Despite the fact that rates are low, bondsquawkers will be the first to tell you that we think the recent rally in the bond markets has some legs to it and rates could head even lower. However and as is the case with a good money manager, it would be imprudent for us to not consider the alternative since it is our philosophy that discipline should always trump conviction, especially in this volatile market. Without question, risk management should be the top doctrine for any investor. With that in mind, Barron’s posted an article as its cover story, on preparing for a rise in yields, whether that’s now or years from now.

Although there’s scant evidence rates are about to jump sharply, bond-fund investors should realize that their risks rise as yields fall. They should make sure they know where the safest exits are. Among many alternatives to avoid rate shock: replace some bond-fund holdings with actual bonds to avoid getting trampled as fellow shareholders sell; diversify your fixed-income portfolio so you’re not too exposed to volatile, rate-sensitive areas; shorten the maturities of your holdings now (or possibly create a “bond ladder”) to make more money available to invest later as the economic outlook clears; buy variable-rate items and possibly snap up securities whose payouts are tied to other types of assets. You should also seriously consider moving some money into creditworthy big-cap stocks that pay healthy dividends.

NERVOUS INVESTORS SEEKING TO preserve their wealth and pick up yield have swarmed into fixed-income funds in the past two years. U.S. taxable bond funds saw estimated net inflows of $152 billion year-to-date through July 7, according to Lipper FMI. In 2009, the full-year total hit $384 billion (see chart, Taxable Bond Fund Flows). To put those figures into perspective, U.S. equity funds saw just $24 billion of inflows through July 7 and only $5 billion for all of last year.

Last week, we wrote that there is no bond bubble due to the fact that inflation is practically non-existent and that there is no evidence of an imbalance in demand as consensus forecasts are for higher rates. Despite this, the Barron’s article reveals that Marilyn Cohen from Envision Capital Management argues that there is a bubble, which stems from her perspective of the tremendous inflows into bond funds. The increase of fund flows, which is usually dictated by past performance and not future outlook ,may spell doom for many investors if rates rise.

The worry is that a pre-emptive monetary tightening by the Federal Reserve, as in 1994, or possibly a big sovereign or corporate default could send much of the bond throng to the other side of the boat. Bond prices would swoon, as they did 16 years ago. Any whiff of inflation—stemming from the Federal Reserve’s massive easing, the Obama administration’s ambitious stimulus and social spending programs, as well as the huge Treasury Department borrowing needs—would spook the whole market. Other countries around the globe, like the U.K., have even more pressing needs for funding.

An interest-rate rise of 1½ percentage points, particularly at these low levels, can be devastating. Take pharmacy retailer CVS Caremark (ticker: CVS). Its 4¾% bonds due May 18, 2020, were recently quoted at a price of 103 to yield 4.372% to maturity. It’s a $450 million investment-grade issue with a solid triple-B-plus rating. But Cohen says it could fall to 92 cents on the dollar and yield 5.871% under the higher rate scenario. That would be an 11% price loss.

To avoid having to sell into such a decline is one reason it’s prudent—if you have the money—to hold at least a portion of your portfolio directly in bonds, rather than shares in a fund. An individual bondholder isn’t forced to dump securities in a falling market, as a fund portfolio manager must when redemptions mount and he needs cash on hand to meet them. The individual bondholder can ride it out, collect his interest and wait until the bond is called by the issuer or matures, to get back all of his principal. Because he owns shares in a fund rather than bonds, a bond-fund investor is stuck: Either he has to bail out or take his lumps as the decline in the value of the fund’s holdings cascades. There is no repayment of principal in a bond fund.

A bond fund can also seem expensive at these rate levels. A typical fund might have an expense ratio of about 1% while providing a return of 3% or 4%. The means your paltry gain is being sliced still thinner.

The article also adds that owning your own bonds is accessible for many investors.

WE’RE NOT SUGGESTING YOU plunge into emerging-markets debt on your own or start swapping high-yield bonds from your desktop computer. Envision’s Cohen, who works with 45 brokers, advises do-it-your-selfers to consult more than one broker to get the best information and prices on bonds. The most popular bonds for retail buyers are typically tax-exempt municipals, Treasuries, Federal agencies and some utility issues. Experts say an individual with an investable portfolio of $500,000-$1 million has the financial wherewithal to own bonds directly.

Another strategy in minimizing the damage done in a rising yield environment is being mindful of your interest rate risk aka duration. In addition, an investor can create a bond ladder strategy for their portfolio.

A popular strategy of investors who own bonds is building a bond ladder—staggering maturity dates so as not to get locked into a particular bond for a long period and face the full blast of increasing rates. In the meantime, you’re getting steady cash flows. As, say, an existing 10-year bond approaches maturity, a new 10-year bond could be placed at the top of the ladder.

For more information on both duration, as a tool for investors, and bond ladder portfolio strategies, visit Bondsquawk’s Bond School.

After all that is said and done, the Barron’s author suggests that fears of a violent move toward higher rates fueled by rampant inflation may be unfounded. Furthermore, in the event that inflation rears its ugly head, the risks for such an environment may be manageable for investors.

OF COURSE, THE WORRIES ABOUT the effects of massive government spending and borrowing—serious as they are—are just that at the moment. Recent government data strongly suggest that a surge in rates isn’t right around the corner. The unemployment rate remains stubbornly high at 9.5%, housing prices fell 3.2% in the first quarter, and inflation is running at about a 2% rate. Economic conditions are “likely to warrant exceptionally low levels of the federal-funds rate for an extended period,” as the Federal Reserve’s monetary policy-makers, the Federal Open Market Committee, put it after their recent meeting.

And even if rates do go higher, they don’t necessarily have to go through the roof. James Kochan, fixed-income strategist at Wells Fargo Funds Management Group, says a measured move is more likely. “With the 10-year [Treasury] in the 3% area, and the yield curve so steep, I don’t think it will go much above 4%,” he says. “There’s a cushion for long maturities.” Just because the Fed notches rates up doesn’t mean that all maturities of debt have to move in step. From 2004 to 2006, when fed-funds went from 1% to 5¼%, longer Treasuries hardly moved, Kochan notes.

Still, the longer-term effects of such a huge increase in government spending and debt, not just in the U.S. but worldwide, are pretty well documented. Eventually inflation—and interest rates—go up, too. Better to hedge your bets now than to get run over by the bond-fund crowd later.