Many investors have a substantial holding of bonds in their portfolio. Where these fixed income assets are invested is becoming more important and managing interest rate risk should be paramount for all bond investors. I prefer the taxable date-specific Guggenheim BulletShares Corporate Bond ETFs as a viable means of generating fixed-income and controlling interest rate risk in a time that appears to be the beginnings of a turn in the long-term rate cycle.
As a refresher, many investors use a widely held and popular bond funds as a proxy for their fixed-income exposure. For this article, we reviewed Kiplinger's Nov 26, 2016 article titled "The 5 Best Bond Funds for 2017 - The trick next year will be to avoid losing money", and decided on reviewing the Pimco Income Fund D (MUTF:PONDX), as described below. Morningstar ranks PONDX as 5 Star and Silver.
"As its name suggests, Pimco Income Fund D focuses on producing income-a rarity at Pimco, where most funds aim to produce above-average total returns. Income yields 3.1%. Like the Metropolitan West fund, Pimco Income has an outsize position in nongovernmental-backed mortgages, at last word 54% of assets. The fund ranges widely, investing in foreign bonds, including a big slug in emerging markets, as well as investment-grade corporate and junk bonds. The fund's duration is 2.8 years. Over the past five years, Income returned an annualized 8.7%. I think the fund will do well, but future returns won't be anywhere near that high. Annual fees are 0.79%."
Morningstar ranks PONDX as 5 Star and Silver, has a current yield of 3.91%, charges 0.79% fees and manages $85.8 billion in bond assets. PONDX has a duration of 2.8 and an average maturity of 6.4 years. In the current portfolio, 38% of bonds are government, 8% corporate, 20% securitized, 16% cash and 16% other. Looking at the growth of $10,000 over the past 10 years, as offered by M* charts, it is not hard to see why this fund could be popular.
Investors usually have four choices for bond investments: a mutual fund, individual bonds, publicly traded "baby bonds", and ETFs.
Some of the attributes of each: A mutual fund buys individual bonds and rolls them over at maturity and the principal is collected. While the bond portfolio has individual maturity dates, the bond fund does not and fund investors receive no proceeds from portfolio maturities. Prices of the fund usually trade based on the NAV of the underlying bond portfolio. Funds can be quite diversified in their holdings. Individual bonds are traded on the open market, are usually sold in lots of $1,000, but priced in $100, and are principal is repaid at maturity along with regular interest payments. Asset diversity is sacrificed for a predetermined maturity date for principal repayment. Publicly traded "baby bonds" trade like many preferred stocks, are usually used by corporations and usually issued with maturities in lots of $25 on a predetermined maturity date. Much like individual bonds, diversity is sacrificed but an ease of trading is attractive for "baby bonds".
Much like their equity brethren, bond ETFs trade like stocks and hold specific types of bonds. The niche I prefer are bond ETFs that offer the ease of trading like "baby bonds", offer asset diversification, and have a specific maturity like individual bonds. These bond ETFs are also called date-specific as the underlying portfolio has maturities in the year designated. Guggenheim offers two different flavors, corporate and high-yield corporate, and calls them BulletShares. Each BulletShare ETF has a specific year for maturity. iShares offer similar date-specific bond ETFs that holds tax-free municipal bonds and taxable government treasury bonds.
Before delving further, a short discussion of the specific bond strategy being implemented should be outlined. I believe we are at a long-term cyclical turn in the interest rate cycle, and once 10-year Treasury note rates are sustained over 3.0%, the long-term downward trend that begin in 1984 will have been broken. I also agree with many forecasters that rates could equal or exceed this level by year's end.
SA contributor and Gerring Capital Partners founder Mr. Eric Parnell offers great interest rate charts on his articles from Jan and just a few weeks ago. The first chart plots the 10-yr Treasury interest rate, CBOE 10-Yr Treasury Yield ($TNX), from 1982 to present; the second charts the 10-Yr Treasury Yield ($UST10Y) over the previous 10 years; and the third chart is of the 30-yr Treasury Yield ($UST30Y), also since 2007.
As shown, in the first chart, the 35-year bull market trend (red line) in bonds led by falling interest rates will be broken when 10-Year rates climb over 2.75% - and stays there. On the chart below it going back to 2007, the same black line indicates a break when rates rise above 2.5%. The bottom chart indicates 30-Yr rates above 3.1% will also mark the end of its downward trend. Regardless of the historic time frame, the charts are telling us that 10-yr rates over 3.0% breaks very long-term trends going back both 35 and 10 years; and 30-yr rates also above 3.1% is a confirmation of the end of the bull market in bonds.
Controversial, yes, but I will go with a rising rate scenario and am planning accordingly.
There are few certainties in investing, but one sure-fire rule is bond prices in the aftermarket trade inversely with the direction of interest rates. As interest rates rise, bond prices decline and as rates decline, bond prices rise. Another sure-fire rule is the longer the maturity, the more price volatility for the same movement in interest rates. Taken together, as interest rates move up, bond prices move lower, with 30-yr bond prices falling faster/more than 10-yr prices and 10-yr prices moving lower than 1-yr prices. The opposite is true as well. As interest rates move down, bond prices move higher, with 30-yr bond prices rising faster/more than 10-yr prices and 10-yr prices moving higher than 1-yr prices.
The financial whiz kids have derived a complex formula to calculate the volatility of a bond portfolio and the result is known as the duration. Morningstar offers the following definition of duration:
"Average effective duration provides a measure of a fund's interest-rate sensitivity. The longer a fund's duration, the more sensitive the fund is to shifts in interest rates. The relationship among funds with different durations is straightforward: A fund with duration of 10 years is expected to be twice as volatile as a fund with a five-year duration. Duration also gives an indication of how a fund's net asset value (NYSE:NAV) will change as interest rates change. A fund with a five-year duration would be expected to lose 5% of its NAV if interest rates rose by 1 percentage point, or gain 5% if interest rates fell by 1 percentage point. Morningstar surveys fund companies for this information."
The formula is: Effective Duration = (P(1) - P(2)) / (2 x P(0) x Y) with P(0) = the bond's original price per $100 worth of par value; P(1) = the price of the bond if the yield were to decrease by Y percent; P(2) = the price of the bond if the yield were to increase by Y percent; Y = the estimated change in yield used to calculate P(1) and P(2). No thanks on that calculation, especially when others have done the calculation for us.
Morningstar and other financial sites offer average effective duration calculations for many bond funds. M* lists duration along with average maturity on the home page of the fund quote.
In other words, if Fund A has a duration of 5.0 and Fund B a duration of 10.0, for every 1% increase in interest rates, Fund A's existing portfolio of bonds is expected to decline by 5% in value while Fund B is expected to decline by 10%. So, an overreaching goal of bond investing is to generate an acceptable yield with as low a duration (risk to principal) as possible, within the credit risk profile desired by the fund owner.
Going back to the example of PONDX, the fund has a duration of 2.8 which means for every 1% rise in rates, the NAV is expected to decline by 2.8%. While this is a pretty low duration number and the yield is acceptable, the fund still has no actual maturity when fund investors will see their principal repaid. Using Vanguard bond funds as further examples, Vanguard Long-term Treasury bond fund (MUTF:VUSTX) has a duration of 16.8, an average maturity of 24.5 years, and a yield of 2.8%. Their Intermediate-Term bond fund (MUTF:VFITX) has a duration of 5.7, an average maturity of 5.2, and a yield of 1.6%. Investors in long maturing bond funds should expect a serious erosion of their principal during times of rising interest rates.
An alternative fixed income strategy is to develop a bond ladder of BulletShares ETFs where, on Dec 31 of each year, an ETF's portfolio matures and the cash proceeds of the NAV are distributed to fund holders. BulletShares are designed to accumulate maturing proceeds until the end of the specific year, and then the ETF liquidates. This allows the ETF holder to reinvest the cash proceeds in the next longer date on the ladder.
Guggenheim offers a BulletShare bond ladder builder tool on its website. Using my own portfolio as an example, I own the following ten ETFs:
- Corporate Bond 2018 (NYSE:BSCI)
- Corporate High Yield Bond 2018 (NYSE:BSJI)
- Corporate Bond 2019 (NYSE:BSCJ)
- Corporate Bond 2020 (NYSE:BSCK)
- Corporate Bond 2021 (NYSE:BSCL)
- Corporate Bond 2022 (NYSE:BSCM)
- Corporate High Yield Bond 2012 (NYSE:BSJM)
- Corporate Bond 2024 (NYSE:BSCO)
- Corporate Bond 2025 (NYSE:BSCP)
- Corporate Bond 2026 (NYSE:BSCQ)
The overall strategy is about equal weighted and ranges from 8% to 14%. As the portfolio is date specific, the analysis tool can calculate a Yield to Maturity of 3.05%, a Distribution Yield of 3.07%, and a Yield to Worst of 2.89%. The effective duration is 4.2 and the overall portfolio contains 2,659 individual bonds.
At the end of each year, the ETF distributes the cash proceeds of individual bond maturities and the ETF terminates. For investors, the cash can be invested in the next longest date on the ladder, and in my case 2027.
However, I short-circuit the process by a year. In the final year, these ETFs are collecting a growing balance of cash and the interest on cash is substantially lower than the bond which mature. During the last year, investors should expect the income from date-specific to decline. To counter, I will watch the rising cash level (also available on M*) and usually sell the fund early in the year, taking those proceeds to build the next rung.
I feel comfortable with this strategy, especially in times of rising rates. My eventual goal is to switch to long US Treasuries if/when yields cross 5.0%, and having a shorter duration ladder helps to preserve my principal. What is your fixed income strategy?
Author's Note: Author owns the BulletShares listed above. Please review disclosure in Author's profile.
Disclosure: I am/we are long BSCI,BSCJ,BSCK, BSCL, BSCM, BSCO, BSCP, BSCQ, BSJI, BSJM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.