A Tough, but Smart Sell

Plenty of clients detest bond mutual funds, their most common gripe: Why own these never-maturing bonds when the Fed is trying to nudge up interest rates? When interest rates rise, bond funds sink, so in times like these many investors feel more comfortable plugging money into an individual bond and holding it to maturity, secure in the knowledge the cash will be there in the end.

But bond prices go up and down too — as clients will discover if they need to sell before maturity. In fact, a fund can be less volatile than a small portfolio of individual bonds. The typical fund is broadly diversified and includes hundreds of names.

“Bond funds can be very stable, which makes them good diversification tools,” says Steve Coggins, a partner with Irongate Partners, a registered investment advisor in Wilmington, N.C.

A Hard Sell

For nervous clients, bond funds may seem particularly hazardous these days. With the Federal Reserve doggedly raising short-term rates, long-term yields seem poised to rise eventually. That brings back memories of 1994, when rates rose and bond funds dropped. Still, bond funds can be ideal instruments for today's erratic markets. Funds have a long record of bouncing back and rewarding patient investors. After losing 7.1 percent in 1994, long government funds returned 27.3 percent in 1995, according to Morningstar.

Funds also offer a kind of flexibility that can be crucial for managing portfolios. If an investor needs to rebalance assets, he can easily buy and sell shares of funds, precisely adjusting the bond allocation. Trading individual bonds can be more cumbersome and require a sizable portfolio.

“If you buy individual bonds, it can be difficult and expensive for retail investors to build a diversified portfolio,” says Steve Savage, managing director of Advisorintelligence.com, a fund advisory service.

In current markets, perhaps the most important virtue of funds is that they often deliver exceptional performance during periods of rising rates. To appreciate why this is so, consider an investor who owns one $1,000 bond that pays 4 percent. Twice each year, the investor can receive an interest payment of $20. If rates rise to 5 percent, the investor could benefit by reinvesting interest payments in a new bond with a higher yield. But to buy another $1,000 bond, the investor might have to save his interest payments for months or years. While waiting to make a purchase, the investor may be forced to hold his interest payments in a low-yielding money market fund. In contrast, a diversified fund portfolio receives interest payments constantly, and the cash can be reinvested immediately in high-yielding bonds.

“To build total returns over time, you need to reinvest interest,” says Zane Brown, director of fixed income for Lord Abbett.

Because of the reinvestment, rising rates can actually benefit long-term fund investors. “If you have a time horizon of five years or more, then you should probably be pleased when rates rise,” says Catherine Gordon, principal with Vanguard Group.

To illustrate the point, Vanguard cites the example of an investor who holds a bond fund for seven years. In the first year, bond yields climb from 4 percent to 5 percent. With bond prices falling, the fund loses 0.8 percent. The next year, rates rise another percentage point. But while bond prices drop, the fund is able to reinvest, buying more high-yielding securities. Eventually, the higher yields more then compensate for any drop in prices of bonds. After seven years, the fund has produced an average annual return of 4.2 percent. Now suppose that instead of rising, rates fell 1 percent in the first year. Thanks to the combination of rising bond prices and interest income, the fund would produce a total return of 8.8 percent for the year. If rates fall another percentage point in the second year, the fund would again show a nice result. But soon the fund would begin slowing down, reinvesting interest in bonds yielding 2 percent. After seven years, the low-yielding fund would only show an annual return of 3.8 percent.

With a Little Patience…

To benefit from rising rates, investors must be able to wait long enough. For a rough gauge of whether a fund might be suitable for a client, consider his investment horizon and the fund's duration, a measure of the investment's sensitivity to changes in interest rates. If a fund has a duration of eight years, then the client must hold the investment for about that long in order to benefit from reinvestments. If the client can only hold for three years, then he runs the risk of selling before reinvestment will compensate for any share price losses.

In theory, a client with a three-decade time horizon is safe holding a long-term bond fund with a duration of 15 years. But many advisors prefer sticking with intermediate-term funds with durations of four to eight years in the current environment. The intermediate funds provide nearly as much yield as long-term players and offer less risk. For the best combination of risk and reward, Savage recommends intermediate-term funds with long records, including Loomis Sayles Bond and PIMCO Total Return.

Clients seeking some extra protection against rising rates should consider Thornburg Limited Term Municipal Bond, a short-term fund. The fund holds a classic bond ladder, keeping roughly 10 percent of its assets in bonds with a maturity of one year, 10 percent in maturities of two years, and so on. The maximum maturity is 10 years. When rates rise, these bonds would suffer a loss. But shareholders who stick around for about five years would be better off because of the reinvestment in higher yields, says portfolio manager George Strickland.

Because of its strategy, Thornburg can enjoy a special advantage over competitors during periods when rates on longer bonds rise sharply. To maintain the ladder, Thornburg does not purchase bonds of various maturities. Instead, the portfolio manager typically buys 10-year bonds and allows them to age. After one year, a 10-year security has a maturity of nine years; after two years, the maturity is eight years. When a bond matures, the manager takes the principal and buys a new 10-year bond. In contrast, the typical short-term bond fund puts new money into securities with a mix of maturities ranging from one to seven years. Because of its strategy, Thornburg does best when 10-year bonds offer rich yields compared to shorter bonds. Lately conditions have not favored Thornburg's approach. Yields on 10-year bonds have been relatively miserly.

“This is probably the time when the laddered approach looks as bad as it gets,” says Strickland. “But we will look better when yields finally pop up.”

Up in the Downs