Bond market investors are wondering what hit them, but they can’t say they weren’t warned.
The Treasury bond market suffered one of its worst monthly declines ever in July, generating a record 11 percent loss for the 30-year Treasury bond, according to Bianco Research in Chicago.
Daily yields on the benchmark 10-year Treasury bond averaged 3.9 percent last month. But holders of major bond mutual funds lost money at about that same rate.
The $42 billion Total Return Institutional Fund managed by Pacific Investment Management Co. (PIMCO) lost 3.7 percent, and the $18 billion Vanguard Total Bond Fund lost 3.3 percent. The benchmark Lehman Brothers index of Treasury securities fell 4.4 percent.
Alarm bells sounded at least eight months ago. Bill Gross of PIMCO, the top-rated bond fund manager, said last December, “The bond market’s salad days are over.”
The prediction got nearly as wide a circulation in the financial press as the “irrational exuberance” comment about the stock market uttered by Federal Reserve Board chief Alan Greenspan in December 1996.
In both cases the comments were premature–Greenspan’s by three years, Gross’ by seven months. But the delayed reaction of financial markets to the revealed dangers probably made the eventual pain worse.
Investors who were introduced to bonds three years ago as an alternative to Nasdaq stocks suffered a shock in July.
“Now you know why I retired at the end of June,” quipped Ian MacKinnon, former head of fixed-income investing at mutual fund giant Vanguard Group.
The Federal Reserve’s announced focus on preempting price deflation in the U.S. economy generated the reverse effect–fear of inflation–in the bond market as the Fed pumped money into the economy, he said.
“With all that money sloshing around, it could be a quite dramatic pickup in inflation, and if that’s the case, the Fed is going to have to slam on the brakes,” MacKinnon said.
Inflation instantly erodes the value of fixed-income investments, with the biggest damage hitting bonds with the longest maturities.
“The market is not going to wait around until they see that kind of flip-flop. They’re dumping long-term bonds today,” MacKinnon said.
No safe harbor
Investors who believed bond investments were a safe harbor in the storm of the stock market’s swoon were caught unaware.
Bond prices, which move opposite to interest rates, stabilized last week. But many analysts predict that the damage is not over, as the economy rebounds and the government floats new debt to finance soaring deficits.
Others say the tepid economic recovery and the pledge by the Federal Reserve to maintain short-term interest rates at 40-year lows bode well for bond prices.
As the debate rages between bond market bulls and bears, “if people don’t look at their bond portfolio as something that needs care and tending, they don’t understand,” said Chicago-based financial adviser Tim Schlindwein.
Investors must accept the fact that nothing is “fixed” about the market for fixed-income securities, which promise to pay regular interest.
“People tend to think of bonds about the way they think of insurance, as something boring that they don’t need to understand,” said Steven Weinstein, president of Altair Advisers in Chicago. “But the bond market is not a monolith.”
Three factors make bond market investing similar to playing three-dimensional chess:
– The multiple components of the bond market–from supersafe Treasury securities, to tax-exempt municipal bonds, to high-risk “junk” corporate bonds–gain or lose value separately as investors assess their special appeal.
“Each of them has very different characteristics and supply-demand issues,” Weinstein said.
For example, signs of a growing economy may hurt the value of long-term Treasury securities, but increase the value of corporate bonds in relation to Treasuries.
“One thing we’ve learned over the last three years is you need to be diversified,” Weinstein said.
– Fixed-income securities in all sectors cover a span of maturities, called the yield curve, from commercial paper and Treasury bills that come due in a matter of weeks to Treasury bonds that come due in 2031. Shocks that hit the bond market–including unexpected Federal Reserve policies, surprising government taxing and spending behavior, sudden skepticism about corporate accounting and the unforeseen defaults by state and local governments–don’t have the same effect across the curve.
As a result, “it’s very hard to time the market,” said Weinstein.
“A few weeks ago we got as defensive as we could,” said Schlindwein. “Now, it’s tempting to put some money back [into bonds]. We’re not sure we’re that smart.”
– When interest rates are historically low, the riskiness of any bond portfolio increases.
“Back when interest rates were 10 percent in the mid-’90s, you could have a 5 percent decline in the prices of bonds and you’d still have a mid-single-digit rate of return,” MacKinnon said.
“But when you’re starting out at 3 or 4 percent yields, it doesn’t take much of a decline in bond prices to wipe out a year’s worth of income,” he said.
“It’s like asking how do you like the Dow at 11,000 with [price-earning ratios] at 45 to 50. There’s not a lot of upside and the downside can be dramatic.”
One way to protect your low-yielding bond portfolio against a surge in inflation is to buy inflation-protected Treasury bonds, called Treasury Inflation-Protected Securities (TIPS), or Series I savings bonds. In both cases, your return is increased along with inflation.
Otherwise, investors face similar choices as they do when holding stocks: active management by a professional bond market investor versus passive management in a bond fund linked to an index of bonds. Short-term investing versus long-term investing.
MacKinnon said the primary decision in constructing a bond portfolio is the average maturity you want in your bonds.
“The thing to do is to find a personal sweet spot on the yield curve,” he said.
This advice runs counter to the popular prescription of owning a “ladder” of bond maturities from short-term to long-term.
The flaw in the ladder is, “you are assuming that each point on the yield curve is the same, but rates seldom go up exactly the same across all levels of the curve,” Weinstein said.
Shorter maturities
Under current market conditions, investors receive little benefit for holding maturities of more than 10 years, MacKinnon agreed.
Most investors “don’t have the ability or interest to be paying a great deal of interest to the slope of the yield curve, which changes from week to week,” he said.
“Once you get beyond 10 years, you get very little incremental income per unit of risk. My personal sweet spot is somewhere between that 3-year and 10-year area.”
After you determine your average maturity target, the remaining question concerns whether to pay for active management by a professional bond investor.
“If you can find an active manager who is low-cost, broadly diversified and conscious of transaction costs, then I would lean more toward active management” instead of a passively managed bond index fund, MacKinnon said.
“The unfortunate aspect of today’s bond market is that most of the managers are not low cost and broadly diversified,” he said. “But if you can find some that are, they have pretty good chances of adding incremental return.”
MacKinnon said you should not pay more than 0.4 percent in expenses to an active bond fund manager. Expense ratios in passive index funds should be 0.2 percent or 0.3 percent, he said.
