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The New Bond Equation

The New Bond Equation

by Michael A. Pollock
Saturday, August 1, 2009

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Investors usually turn to these funds for safety. But bond funds are facing a host of pressures that are driving down returns, raising long-term risk -- and making it tougher to settle on the right investment strategy.

Take funds that focus on long-term Treasurys. These have often been an easy choice for a safe haven. But after frenzied buying of Treasurys last fall when the financial crisis became acute, prices have fallen as broader fears have eased and some of that money has come back out of the government-bond market.

There's also concern about the huge amount of debt the Treasury Department must sell to finance higher federal spending.

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The result? Funds focused on these bonds are down 13% this year, according to Morningstar Inc. "Treasurys, which are considered the risk-free asset class, probably are the riskiest asset class right now" among fixed-income options, says Robert Gahagan, team leader for U.S. taxable bond investments at American Century Investment Management Inc.

As for municipal-bond funds, lots of states and localities are strapped for cash, which raises the specter of defaults -- and makes their bonds a riskier investment. Likewise, corporate-bond defaults are high and still rising.

Even money-market funds are under pressure these days. The older securities that such funds bought when rates were higher are maturing, and those available now pay paltry yields because the Federal Reserve is keeping short-term rates low to spur economic growth. So, even the highest-yielding funds have annualized yields of less than 1%.

In this tough environment, many investors are steering for the middle of the road. Instead of looking for long-term-bond funds -- which could get slammed if rates rise in the near term -- they're buying vehicles that invest in intermediate-maturity bonds. These funds also typically hold a mix of government, mortgage and investment-grade corporate bonds, which spreads risk around. Even cautious intermediate-bond funds yield about 4%, handily beating rates available on money-market funds.

"It's a good idea for investors to have exposure to nongovernment sectors, like corporate bonds, that offer a bit more of a yield cushion and diversification," says Miriam Sjoblom, an analyst at Morningstar.

So, what should bond-fund investors be watching out for these days? Here are five key pointers.

Watch Out for Defaults

If you head into a bond fund, pay close attention to the types of bonds it holds. Some of the most popular choices -- corporate bonds and munis -- carry greater risks these days.

With corporate bonds, it's probably better to avoid funds that have loaded up on speculative-grade, or "junk," issues -- those rated at or below Ba1 by Moody's or double-B-plus by Standard & Poor's. Last year, some intermediate-bond funds that owned a lot of riskier securities were down 25% or more on panic selling.

And now? Moody's Investors Service says by the end of June, 11% of some 1,500 U.S. speculative-grade corporate issuers it tracks had defaulted on debt during the previous 12 months, up from 8% at the end of March. Moody's expects that rate to reach about 13% by year-end and then to start dropping.

Check a fund's prospectus for its policies about investing in riskier bonds and check shareholder reports or resources such as for a fund's recent exposure. But even investment-grade corporate bonds can suffer ratings downgrades, and they can lose value in trading just on speculation that an issuer is running into difficulty. So, you might look for bond funds that make a point of investing very defensively in these types of securities.

For instance, RidgeWorth Intermediate Bond recently held around 97% of its $1.3 billion portfolio in bonds rated investment grade. The fund is avoiding financial-company bonds while buying utility, consumer-staple and pharmaceutical issues, says RidgeWorth Investments fund manager Jim Keegan. Such choices reflect the view of Mr. Keegan and his colleagues that the U.S. economy will remain weak for an extended period.

Meanwhile, recognize there's also more credit risk than usual in the municipal-bond market, where defaults historically have been very rare. Recently, as California lawmakers deadlocked over how to close a $24 billion state budget gap, ratings agencies cut the state's general-obligation-bond rating -- the credit rating of bonds backed by the full faith and credit of the state -- and ratings for other bonds issued by the state and related entities.

Muni-bond specialists doubt that any state actually will default -- but even the threat of a downgrade could cause a state's bonds to trade lower in the market and hurt the net asset value of a muni-bond fund. Moreover, big budget cuts at the state level will pressure finances of local governments -- possibly raising the specter of defaults and hurting their bonds on the market.

Limit Your Rate Risk

As the economy eventually strengthens, investors may need to start worrying about interest-rate risk -- the threat that rising rates will push down the prices of existing bonds.

Generally, the longer the maturities a bond fund owns, the more sensitive it is to a broad move in yields. This sensitivity, called duration, is a measure based on a portfolio's average maturity and fixed interest rate. By checking a fund's duration -- which fund firms disclose periodically with portfolio holdings -- you can see how any broad rise in yields might affect a fund's value.

Multiply the duration figure by a given percentage-point change in yields. Worried that yields are going to rise by one percentage point? A portfolio with a duration of 10 could lose about 10% of its principal value in that scenario.

Given the risk, it may be smart to shift to a shorter-maturity bond fund, even though that will generally produce a lower yield. Many managers of taxable intermediate-term-bond funds keep duration at around four years, which they believe enables them to get good yields without taking a great deal of rate risk. Stephen Mahoney, who manages Glenmede Core Fixed Income, recently has been keeping duration modestly above four.

If four years is too much for your risk tolerance, you can look for even lower durations. One fund that fits the bill, and is a pick of Morningstar's Ms. Sjoblom, is FPA New Income. It returned 4.3% last year, and its duration recently stood at 1.1 years.

Interest-rate risk is a particular concern for holders of munis, which often are sold in maturities as long as 30 years. As a result, muni-fund durations often exceed those of taxable-bond funds. "The typical municipal fund may have a 20-year average maturity and a 15-year duration," says Warren Pierson, who helps manage Baird Intermediate Municipal Bond. "So investors in such a fund potentially could be looking at a 15% loss of principal" if interest rates rise one percentage point.

The Baird fund invests in shorter maturities and has a duration of less than five. It ranks in the top 2% of Morningstar's national intermediate-term municipal category for five years and last year posted a total return of 6%.

Consider a Passive Strategy

Last year, most actively managed bond funds performed worse than bond-market benchmarks such as the Barclays Capital U.S. Aggregate Bond Index. The trouble: They had lower weightings in government bonds than the indexes did, or they were trying to boost yields through positions in complex, difficult-to-trade securities.

So, are investors better off opting for an open-end fund or exchange-traded fund that tracks an index? Indexed portfolios eliminate any possibility that a manager might bet the ranch on a risky strategy, and they offer much greater transparency. Indexed portfolios also charge relatively low management expenses, leaving more of what they earn for investors.

However, some that are based on smaller baskets of securities could suffer more proportionately if just a few of the bonds in the basket run into trouble.

One ETF that offers considerable diversification as well as low interest-rate risk is the iShares Barclays 1-3 Year Credit fund. Its portfolio comprises 425 securities with an average credit rating of single-A and a duration of less than two, though some investors may not like the fact that its holdings include a lot of financial institutions. A 6.29% gain in net asset value in the first half of this year put the fund in the top tier of Morningstar's short-term-bond fund category for that period.

Have an Inflation Hedge

Should you worry about inflation? It depends on your time horizon. With so much slack in the economy, few economists see near-term risk. And funds that hedge against inflation were slammed last year as investors fretted more about deflation.

But the government's stimulus efforts create potential for inflation to flare eventually. And despite its mission to limit inflation, the Federal Reserve will face strong political pressure to keep stoking economic growth as long as the economy is weak, says Ken Volpert, head of the taxable-bond unit at fund giant Vanguard Group Inc.

One option is funds that invest in Treasury inflation-protected securities, or TIPS, whose principal amount is adjusted for changes in the consumer-price index. A low-fee option is Vanguard Inflation-Protected Securities, which basically just owns TIPS. Morningstar also gives high marks to Harbor Real Return, which owns TIPS and some other types of bonds, and Pimco CommodityRealReturn Strategy, which owns TIPS but also uses derivatives to capture moves in commodities markets.

Don't Try to Time the Market

As is true for all markets, the outlook for bonds is clouded by a great deal of uncertainty. Yields can move significantly as market sentiment shifts about the prognosis for the economy, interest rates and inflation. "No matter what move they make, investors should brace themselves for more volatility ahead as the market's attitude toward risk continues to fluctuate," says Ms. Sjoblom of Morningstar.

Don't assume, for instance, that you'll be savvy enough to anticipate a broad climb in interest rates and thus be able to jump out of a long-term-bond fund before it suffers a significant decline in net asset value.

Rather than making big changes in your portfolio all at once, you might shift smaller sums at regular intervals, to reduce the risk of making a poorly timed investment. Most fund sponsors have Web sites that enable you to manage your positions. You can use them to arrange periodic automatic transfers of money into one or more funds from a bank account.