Posts Tagged ‘bonds’

One of the recurring themes with mutual funds investing is the topic of investment management (it has been stressed throughout these posts). And this, naturally, is where bond funds slip onto the scene. As with every good investment management strategy, bond funds fill the all-important but often overlooked fixed-income pocket of your portfolio. But not all bond funds are created equally. In fact, unlike straightforward equity funds where an equity is an equity is an equity, your bond funds will involve different types of fixed income assets, each of which can have different sensitivities to the same market impulses.

In periods of low interest rates, bonds funds are usually a place to avoid. The reason for this is simply because rates and bond prices have an inverse relationship. In other words, when rates start to rise, bond prices start to drop. However, even in periods of low interest rates, there are opportunities in bonds and bond funds, but the decision as to where to invest (e.g. long-term, short-term, muni, corporate, junk, etc., etc., etc..) is much more complicated.

In periods of elevated interest rates, bonds become more attractive because along with the higher income, the potential for falling rates enables the investor to enjoy capital gains in the price of the underlying bonds. The problem when it comes to bond funds is determining whether the fund manager bought too low, whether the fund manager has cash sitting in the bank that will allow for additional purchases at these elevated rates, whether the manager will have to offload bonds at a loss and so on.

In some ways, investing in bonds individually can sometimes be easier than investing in a bond fund where the investor buys the whole package rather than being able to cherry-pick the winners and ignoring the losers.

Why This Time It Really Is Different

There are many reasons why the search for properly performing bond funds is different this time around. Much of it has to do with what caused the economic collapse in the first place; credit and risk underwriting. This resulted in credit-granters withholding funds in an effort to stem potential losses. This is normal. A child who burns himself on the stove will not want to cook until he realizes what he can do to avoid getting burnt again.

However, even the most risk-averse credit granters realized that some companies seeking credit actually were still credit-worthy. However, to offset the risks associated with lending money, rates increased substantially while rates that governments were paying were on the way down. This is what is meant by the “spread” between corporate and government bonds. Where that spread is normally more narrow, those spreads were rather wide over the past two years. They are currently in the process of narrowing.

The narrowing of the spreads involves two event.

The first is that corporate bond rates drop. This is good news for the higher-rate bond holders as their bond values will increase and their income will remain constant.

The second event is government bond rates start to increase. This is bad news for the bond holders because not only is income low, but those prices will start to drop as well.

Where the unlucky investor stands to lose is in buying the wrong bond fund. While it may seem safe and cozy to invest in government bonds as the risk is lower than corporate bonds, the true risk lies in the fact that government rates will start to increase. This puts downward pressure on the price of those bonds, causing the investor to realize a capital loss.

The better decision would be to invest in bond funds that are corporate in nature; high yield investments. This makes better sense, especially as the risks involved with these bonds and companies disappear and the rates start to drop. This could take well over one year or more to happen, making high yield investments ideal for 2010. (See High Yield Investments: Top Pick for 2010 post for our choice for this year). However, an active investor might way to trade out of such bond funds as government rates become inflated and switch to government bond funds.

Not very long ago, the idea of the income asset class, and bond funds in particular was to provide a decent level of interest income. A nice byproduct of bond funds was some of growth potential they had when bought at discounts or sold at premiums. Such mutual funds were rather blase, boring, even cookie cutter. But insofar as investment management was concerned, bond funds made a lot of sense. They paid better than cash-equivalent funds and for those rates they were still considered liquid; you were never locked in with these bonds funds like you might have been with a term deposit.

But bond funds of yesterday were a little misleading. They filled a void, sure. But they were boring underperformers that betrayed the true potential for wealth that bonds can offer. And for many income class investors, that potential for wealth was and still is tremendous.

One of the reasons why bond funds offer such great potential is thanks to nothing other than this most recent recession the entire world has had the (dis)pleasure of enduring. Perhaps the biggest benefit has come in the form of higher borrowing costs for corporate entities, all while government rates dropped to unprecedented lows. This, in turn created wider-than-normal spreads, presenting an historic opportunity for investors who are new to the income class.

Where investors stand to benefit however is in the arena of high yield investments, themselves bonds. What distinguishes these high yield investments from traditional investment-grade bonds is the coupon rate, or the rate of interest that the companies must pay to the bond holders. In the case of high yield investments, the rates paid are considerably higher than investment-grade or even government bonds because a lot of the companies whose bonds are held within the portfolio have been downgraded by rating companies like Moody’s and Standard and Poor’s.

In fact, many of the companies whose bonds make up the portfolios of these bond funds were rated as investment-grade just a couple of years ago but ever since the rating companies came under fire for some of the ratings they gave to some of those fancy Collateralized Debt Obligations (CDO’s, remember those?). Ultimately, the high yield bond funds are below investment-grade with BBB, BB, B ratings and some rated below B.

But, of course, the companies that issue these bonds need to pledge collateral against these bonds. This collateral is often an important asset to the company, vital to its ability to generate income. Now, consider a company that has bonds against which is pledged a considerably important asset to that company’s success. In addition to this debt, the company has probably issued common stock, or equity. In some cases, there may even be a dividend to be paid on such common stock, but it is rather unlikely (though not impossible) for below investment grade common stock.

A quick review of this scenario reveals that the first people to get paid first are the bond holders. So if there ever were any financial troubles, the bond holders would be paid first. The company, not wanting to risk losing this asset, vital to its ability to generate a single dollar, will do everything in its financial power to ensure their bond holders, where such bonds are investment grade or not, are satisfied. That the terms of their agreement are met.

And with spreads as wide as they are, all companies are paying a considerably higher coupon on their bonds. Therein lies the true opportunity for bond funds…. until those spreads start to narrow. And they will narrow, there is no question. As the economy recovers, all spreads will narrow. Government bond rates will rise and corporate bond rates will drop. Existing corporate bond prices will increase while government issues will drop.

So, in a nutshell high yield bond funds offer a great opportunity right about now. Most bond funds hold securities where the coupon is high. As rates drop, so will the bond price (that inverse relationship is a pretty thing). This helps with capital appreciation. But since the coupon was high to start with, there is also a nice trickle of income being poured into the investment. In essence, today’s high yield bond funds are not the same as the bond funds of yesterday. In fact, they are better. How much better comes down to an average yield of 10+% and 2009 performance of better than 35%.

It will probably come as a surprise to many investors that Bond funds offer as many practical options as many of the equity funds on the market. As far as bond funds are concerned, you can have core bond funds that are high quality, low risk and you can high yield bond funds that offer mid quality and medium/high risk.

For many people, bond funds offer a great alternative to term-deposits. Not only do bond funds offer liquidity as well as higher rates of returns (than comparable term deposits), but they are an asset class all their own that allows investors to tactically shore up their asset allocation model.

For a limited few, bond funds present a tremendous opportunity. Since bonds do offer growth potential, there are tax advantages to owning bonds over other income-paying investments. In its most basic format, bonds bought at a discount and held to maturity allow for capital gains rather than straight income. In some (okay, most) jurisdictions, capital gains offer benefits at taxation time.  (However, if taxation is a primary concern when it comes to your investment strategy, you should consult your tax accountant to determine the best income source).

Since bond funds offer investors the opportunity to properly diversify their holdings, it has a considerable importance when it comes to your asset allocation model. The problem is that most investors have a tough time understanding the intricacies of bond funds. For example, bond prices will fluctuate based on many of the same factors that affect equity prices like currency, geopolitical, commodity as well as corporate risks.

The difference is that most bond funds will respond differently to those influences. As such, investors whose knowledge falls short on bonds need to align themselves with an advisor who does have something of a decent knowledge base when it comes to this asset class.