Hard Times Investing

Hard Times Investing: Fixed Income May Have Life In It Yet

Abby Schultz,|Special to CNBC
Key Points

Best strategy is hold diversified bond portfolio.

Emerging-maket bonds go well with weakening dollar.

High-yield bonds can be buiffer for stocks.

With interest rates at or near historic lows, you may think it is time to flee the bond market.

Don't, say experts. Instead, investors should broaden the array of bonds in their portfolio, and, if they are willing to take on risk, add emerging market bonds, high-yield corporates or floating-rate bank loans.

“We’re trying to have investors take a step back from the cliff. Despite the talk of a bond bubble or a bond bear market, it’s not the end of the world for a diversified investor,” says Christopher Philips, an investment analyst in the Vanguard Investment Strategy Group.

That’s because bonds are a great buffer in any portfolio at any time, say analysts.

Since 1973, in fact, Treasurys have had only three calendar years of negative returns: a 3.56- percent loss in 2009, a 3.38-percent loss in 1994 (a year the Federal Reserve rapidly boosted short-term rates) and a 2.55-percent loss in 1999. Compare that to the 40 percent nosedive stocks took in 2008.

Diversify And Conquer

The best strategy for bond investors, though, is to diversify and buy bonds of different durations and credit risk, as well as from different issuers—corporations and government—says Philips.

Consider this: As investors sought safety in 2008, corporate bonds lost 4.94 percent and Treasury bonds gained 13.74 percent. The trend reversed in 2009: corporate bonds gained 18.68 percent while Treasurys lost 3.56 percent.

An investor seeking to avoid volatile swings would have been better off with a diversified portfolio of bonds, such as those that track the Barclay’s Capital U.S. Aggregate Bond Index, says Philips, which gained 5.24 percent and 5.93 percent in the two periods.

"So a diversified approach led to very stable returns for the average bond investor in spite of some of the most volatile markets in history."

While bonds can provide investors with relative safety, and lower volatility than stocks, they aren't foolproof, and investors should temper their expectations, cautions Miriam Sjoblom, an associate director of fund analysis at Morningstar, the fund tracking firm.

"A scenario where interest rates rose suddenly could also cause many bond funds to experience losses in the short run," Sjoblom said.

That's what happened in the 1994 period, when the speed and ferocity of the Fed's tightening caught investors off guard.

If you're among those wondering how much lower Treasury yields can go with the ten-year note already below 3 percent, some big institutional investors are making bets on long-term Treasurys as a hedge against deflation, or a long-term decline in prices, on the assumption investors will continue to flock to the safety of government bonds, sending rates even lower.

Retail individual investors, however, should avoid this strategy, says Payson Swaffield, chief income investment officer at Eaton Vance Management, citing mutual fund data that shows most individual investors already own plenty of long-term Treasury securities, so they’re covered should deflation take hold.

Also, the Federal Reserve is likely to step in and counteract deflation so any incidence would be fleeting, he says.

“For those who are convinced deflation is around the corner, a bet on long-term Treasurys is an attempt to make a ton of money, not to protect capital,” Sjoblom said.

Three Ways To Go

Swaffield at Eaton Vance recommends investors consider diversifying into floating-rate bank loans, emerging market bonds, and high-yield corporate or “junk” bonds.

These sectors yield more than comparable Treasury securities, protecting investors with extra income and the potential for appreciation should the economy strengthen.

Floating-rate bank loans yield a spread over Libor (the London interbank offered rate). If the Federal Reserve raises the Fed Funds rate, Libor moves up, and that gives an investor protection against inflation, says Swaffield.

Floating-rate loans now yield 300-450 basis points over Libor, instead of a more typical spread of 200-300 basis points, so there’s room for spreads to tighten, he said.

“What that means is not only are investors positioning themselves if rates go up, even if rates don’t go up, they are beginning from a very attractive credit spread,” says Swaffield. “As the economy improves, one would expect credit spreads to narrow, and that leads to potential price appreciation.”

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High-yield bonds not only deliver extra yield, they can be a buffer to stocks. Prices of high-yield bonds have dropped less than the S&P 500, and have delivered good price appreciation and returns over the last five, ten and 20 years through June 30, says Swaffield.

Similarly, emerging market bonds trade at higher yield spreads to Treasurys. The most attractive emerging market bonds are bought in the local currency of countries with more attractive balance sheets than U.S. or other developed countries, says Swaffield.

The value of these bonds aren’t tied to Fed policy or the health of the US economy, and by investing in the local currencies, instead of dollar-denominated bonds from emerging markets, investors directly benefit from the strength of these growing economies.

To diversify, investors can buy specific bonds directly, a strategy that ensures no loss of principal should the bond be held until it matures. Or investors can buy a bond fund, which is in an investment in an asset pool of bonds — in other words, investors are not clipping coupons here, they're benefiting, or not, from the total returns achieved by the fund.

Funds spare investors the time and work involved in researching individual bonds, and perhaps more importantly, the money from commissions and other transaction costs, says Vanguard's Philips said. Fund managers also have more negotiating power in the marketplace and command better prices.

Fund investors can diversify by buying a mixture of funds, or by purchasing a diversified fund that invests in a smattering of investment grade corporates and governments, or a multisector fund that goes farther afield into categories like junk bonds and emerging markets.

Daniel Janis and Tom Goggins, managers of John Hancock Strategic Income, a multisector fund that invests in emerging markets, junk bonds and U.S. Treasurys, shift the allocations in their fund based on their outlook for rates and the global economy.

Janis and Goggins expect interest rates will rise gradually, moving from neutral to higher in the next nine-to-12 months. The strategy for its domestic holdings: more credit risk and less interest-rate risk.

Investing in junk bonds was a more profitable strategy in 2009 than it is likely to be in 2010, now that spreads on high-yield bonds are closer to historical levels. Still, it makes more sense to do the research and buy high-yield bonds over investment-grade corporates, because of the extra yield and the continued promise of price appreciation, says Janis.

“Maybe high yield will return in the high single digits to low double-digit returns,” he said.

John Hancock Strategic Income is also investing in the emerging market bonds of Asian countries, including Singapore, Indonesia and Korea, economies that are growing quickly. With Asian bonds, the funds can “capture income appreciation, as well capital appreciation, and forex gains,” says Janis.

Whether investing in individual bonds, bond sector funds or diversified bond funds, investors should stick to bonds even if rates rise, according to Vanguard.

That's because losses in U.S. Treasurys are unlikely to be significant even if rates rise 200 basis points, Vanguard concluded in a recent study. Moreover, Vanguard found in its research that returns for bonds in the 12 months after a 200-basis point spike are likely to be positive.

The conclusion, says Philips, is stick with bonds.

“We found that pretty consistently, following that [2-percentage point]rise, bond investors were much better off had they stuck true to their investment plan,” he said.