How To Solve Your Bond Fund Problem

by: John Gerard Lewis

The Fed’s low-rate policy has left retirees gasping.

Mutual funds, exchange-traded funds and closed-end funds, the diversified vehicles used by most investors to invest in bonds, are susceptible to declining values as interest rates rise.

Invest in individual, investment-grade corporate bonds.

If ever there existed a conundrum for fixed-income investors, this is it.

It was easy to continue reaping bond income amid a 31-year decline in rates. After all, when you start with the 10-Year Treasury Note at almost 16%, there's a lot of good income to be had even in a slow decline, especially with inflation decreasing apace.

And yields weren't where all the goodies were, either. As rates fell, bond principal values appreciated. You really couldn't lose by investing in bonds over the past three decades.

But what began in the summer of 1981 ended in the summer of 2012, when the 10-Year dipped below 1.5%. Then it rose a percent or two, eroding principal value, and in recent weeks has danced between 2.10% and 2.40%.

Fixed-income investors have been rendered helpless. The Fed's low-rate policy, touted as the cure to an inert economy, has left retirees gasping. There is no material gap between short- to intermediate-term investment-grade yields and the inflation rate. For individuals, this means lost purchasing power.

The situation has become so historically irregular that aberrant strategies are emerging from the most orthodox of sources. Vanguard Funds founder Jack Bogle, who trailblazed Steady-Eddy index-fund investing and is hardly a risk taker, now touts yield-over-principal for some income seekers. In other words, don't worry about the vacillation of your bond fund's price, which would reduce your principal amid rising rates. Just forget about that, he says, and instead focus on the fund's yield -- because it's the monthly check, not principal value, that matters to people who need regular income.

Well, that's one way to deal with persistently low rates. But it's probably not the way that Mr. Bogle is handling his own bond investing these days. He and others who don't need a high rate of return for daily living are loath to abide a decline in net worth.

But mutual funds, exchange-traded funds and closed-end funds, the diversified vehicles used by most investors to invest in bonds, are susceptible to declining values as interest rates rise, as we are widely assured they will sometime next year. Generally, the longer the average maturity of the fund, the greater the impact of rising rates. That's why so many pundits have been cautiously advising to keep your maturities short so that you'll have money to reinvest as rates rise.

Well, we've been hearing this for several years now. Rates remain near historic lows but the "keep maturities short" advice has resulted in keeping returns pretty short, too. And even ultrashort bond funds, which hold debt that matures in less than a year, can fall in price when rates rise. They lost an average of 7.9% in 2008, according to Morningstar.

That wouldn't be such a problem for fund investors if they knew they could recoup their invested principal at a specific date down the road. But funds (excepting target-date-maturity funds) don't have maturity dates, because they're constantly changing their bond portfolios to replace matured bonds with replacements. Therefore, the value of your fund, at any point in the future, cannot be predicted. Even if you know that you're going to hold the fund to a specific date, let's say March 18, 2019, you do not know today what the price of the fund, and thus the value of your investment, will be on that day.

My solution? Invest in individual, investment-grade (rated at least BBB-) corporate bonds. Granted, that prospect strikes many as too complex and even arcane. But it's not. You simply determine the farthest date in the future to which you're willing to hold a bond, and then build a bond ladder to that date.

For example, if you're age 60 and think you'll live to at least 75, you might buy 15 bonds allocated in equal parts (of three bonds) to maturities of under three years, three to six years, six to nine years, nine to 12 years, and 12 to 15 years. As your bonds mature, you simply reinvest the proceeds at the long end.

The advantage is clear: your invested principal is no longer subject to the whims of interest rates, unless, of course, you find that you need to sell a bond before its maturity. Investing in specific investment-grade bonds, as opposed to bond funds, gives you assurance that, barring an unlikely default, you'll get your principal and interest back on a certain date, something that most funds cannot do.

Here's a sample portfolio, with yields as of Oct. 7 (issuer, coupon, maturity, yield to maturity):

Under 3 Years:

Safeway 6.35%, 8/15/17, 4.075%

Compass Bank 6.4%, 10/1/17, 2.412%

Petrobras 3.25%, 3/17/17, 2.152%

3 to 6 Years:

Avon Products 6.5%, 3/1/19, 4.177%

International Game Technology, 7.5%, 6/15/19, 3.838%

Prospect Capital, 5.0%, 7/15/19, 3.687%

6 to 9 Years:

Transocean 6.5%, 11/15/20, 5.233%

United Telephone-Fla. 7.125%, 7/15/23, 4.515%

Barrick Gold 4.1%, 5/1/23, 4.338%

9 to 12 Years:

MBIA 7%, 12/15/25, 5.664%

Braskem Finance 6.45%, 2/3/24, 5.571%

Allegheny Ludlum 6.95%, 12/15/25, 4.963%

12 to 15 Years:

Masco 7.75%, 8/1/29, 6.049%

Global Marine 7%, 6/1/28, 5.525%

Food Lion 8.05%, 4/15/27, 5.32%

With the promise of rising interest rates, and declining bond values, this is the way that I like to invest. Rates may rise, but I know exactly how much each investment will have provided when I cease holding it. This strategy makes investing manageable amid rising rates.

One additional caution: Buy only non-callable bonds, unless you understand what the term "yield-to-worst" means. A callable bond can be redeemed by the issuer for less than you paid for it.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author owns bonds of Petrobras and Safeway.