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 Contemplating the end of a 30-year bull run in bond prices is a bit
like waiting to go to the dentist for some long-needed procedure.
You know it needs to happen, but you procrastinate.
The end of the bond rally has been telegraphed for more than a year,
so it needn't be painful if you prepare for it now.
Some of the conventional wisdom on avoiding all bonds except for
short-maturity issues may be flawed. There are alternatives that can
make sense while producing modest yield.
If you want to sacrifice yield now for protection later, consider a
floating-rate bond fund that invests in securities with variable
interest rates. Here are two funds to think about:
* The SPDR Barclays Capital Investment Grade Floating Rate ETF, for
example, has little risk of losing money when rates rise. It gained
nearly 1 percent last year as the Barclays U.S. Aggregate Bond Total
Return Index – a benchmark for the lion's share of the U.S. bond
market – lost 0.2 percent. It charges 0.15 percent for annual
management expenses.
The sacrifice part is the short-term return: the SPDR fund is up
only 0.14 percent for the 12 months through June 27, compared with
more than 4 percent for the Barclays Index.
* The iShares Core US Aggregate Bond ETF, which tracks the Barclays
index with moderate risk, is up 4.3 percent for the 12 months
through June 27. It charges 0.08 percent a year in expenses. I hold
it in my 401(k) as a proxy for the American bond market.
This fund would give you more yield than the SPDR fund and broader
exposure to the wider U.S. bond market.
BE WARY OF THE YIELD CURVE
What about the traditional advice in a rising-rate environment - in
which most bond prices fall - to go to bonds with short maturities?
Keep in mind that you face loss of yield and some volatility if you
switch from bonds with maturities from five to 10 years to bonds
that mature in under five years.
"The short end of the yield curve may not be a safe haven in the
years ahead," says Joel Dickson, a senior investment strategist in
the Vanguard Investment Strategy Group in Malvern, Pennsylvania.
There also may be some shocks in store in long-maturity bonds as the
Federal Reserve retreats from its bond-buying stimulus program later
this year.
Danger also lies in short rates rising rapidly, according to John
Blank, chief equity strategist for Zacks Investments in Chicago.
"Once they start rising, long-term interest rates can shoot up from
their place between a range from 2.5 percent to 3 percent to close
to 4 percent — all in a few weeks. That is enough to shock fixed
income markets and change the dynamics of global asset allocation
dramatically," he wrote in a recent commentary.
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WHAT NOT TO DO
One of the worst tactics is to look at returns from past years in
bond funds and expect them to continue or to think that traditional
bond funds are safe havens. Past returns provide no protection
against future interest-rate hikes.
Last year's hiccup in the bond market proved that even the most
well-known funds are prone to losses. The A shares of the Pimco
Total Return fund, one of the largest bond funds in the world, lost
2.3 percent last year. It's up about 4.5 percent for the 12 months
through June 27. Longer-term, though, the fund has handily beaten
the U.S. bond market's main benchmark over the past three-, five-
10- and 15-year periods.
But can you expect the Pimco fund, managed by embattled management
legend Bill Gross, to live up to high expectations based on past
returns? Thousands of investors don't think so, as the $229 billion
fund has had some $50 billion in redemptions in the past year. The
fund charges 0.85 percent for annual expenses in addition to a
3.75-percent sales charge.
Noting investor dissatisfaction two weeks ago at the Morningstar
conference in Chicago, Gross sardonically called himself a
"70-year-old Justin Bieber," referring to the troubled pop star.
Gross said the "new neutral" environment will depend upon what
happens when the Federal Reserve stops buying Treasury bonds in
November. "The bond market has feasted on Fed buying," Gross noted.
At the very least, investors should fine-tune their portfolio's
exposure to bond-market risk. Every bond fund has a "duration"
measure that will tell you how much the fund will decline if
interest rates rise one percentage point. The Pimco fund's duration,
for example is around 5 percent.
Also keep a close eye on expense risk. It makes little sense to pay
a sales charge for a bond fund or tolerate high expenses. That's why
exchange-traded bond index funds are the best deals. High expenses
eat into total return, which is low to begin with. You will have
even more risk of losing money if you're trading bonds and don't
hold them to maturity or hold interest-rate sensitive securities
like real estate investment trusts or preferred stocks.
(Follow us @ReutersMoney or at http://www.reuters.com/finance/personal-finance;
Editing by Beth Pinsker and Dan Grebler)
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