Last spring, fixed income investors' thoughts were not turning to love, but to risk.
Until June of this year, the U.S. debt market had become known for promiscuous amounts of easy lending, loose lending terms, and most important, a lusty drive for yield in an age of tightening spreads. But what a difference a summer makes. By August, these same investors had found chastity-in the form of higher-quality corporate bonds and Treasuries.
Those who were virtuous and patient bet on Treasuries earlier this year-rightly figuring that there would be a cut in interest rates and that they would be better off eschewing the dangerous subprime mortgage and high-yield areas-and they were finally rewarded by the Federal Reserve's eyebrow-raising 50 basis point target federal funds rate cut on September 18. Another quarter-point cut came on October 31.
"This year, the government bonds have been near the top," says Scott Berry, a senior analyst at Morningstar, who included in that group short-term, long-term and intermediate government bonds as well as Treasury Inflation-Protected Securities (TIPS). "And that reflects that flight to quality. Investors are placing a bigger premium on security than they have in recent years."
The fixed-income market has been pummeled and whipsawed this year. A big bond sell-off in June pushed the yield on the 10-year Treasury bond to 5.25%-based on an anticipated interest rate hike and other technical issues that stressed longer-dated maturities. But then prices shot back up as investors sought shelter during the summer. In fact, step back from all the volatility, and managers remind you that bonds are in black territory this year. As of October 30, the Lehman Brothers Mortgage-Backed Securities Index had returned 5.13% year to date; the corporate index delivered 4.32%; the U.S. Treasury index was up 6.18%; and the TIPS index returned 8.05%.
The fixed-income market's fortunes this year have played out against the drama of the subprime mortgage meltdown, when investment banks and investors realized that a lot of bad debt was sloshing through the market, and was being carried around in strange vehicles such as CDOs and CLOs, instruments about as inscrutable as the silver suitcases on the TV game show Deal or No Deal. What was inside them ended up destroying two giant hedge funds at Bear Stearns, as well as compromising investment bank portfolios, and causing some big heads to roll. Credit market taps froze shut. Collateral was called in. Everything shut down.
"The summer event was just a wholesale assessment of risk-taking," says Dan Shackelford, manager of the $7 billion New Income Fund at T. Rowe Price in Baltimore. "We really saw the symptoms of what leverage and structure had done to risk assets in the U.S., and I think you also saw a wholesale reaction during the summer to other traditional risk assets in the bond market such as emerging market bonds, and it sort of gave people an opportunity to reassess."
On the investment-grade side of the bond spectrum, investors have been forced to play a guessing game about what the Federal Reserve will do next: continue to cut interest rates in order to goose economic growth-or ratchet rates back up to curb inflation and help the depressed dollar. When rate increases were factored into bonds earlier in the year, the bond market is now priced for rate cuts, but investors are starting to worry the Ben Bernanke Fed may have cut rates for the final time on October 31.
That doesn't satisfy many financial planners, who see diminished prospects for total bond returns in the future, and fear long-term inflation will spoil the asset class's good looks. "The only perspective I can give on bonds," says Bob Haley of Advanced Wealth Management in Portland, Ore., "is that we have not used them much for a long time and it comes back to my view that inflation is being artificially suppressed and underreported, and sooner or later you take into [consideration] possible accounting irregularities, the declining dollar, and take what I consider to be real inflation, and I think bonds are a catastrophe waiting to happen."
Of course, Haley got into the business around 1982, when Treasuries were running at a 13%-14% yield, and his feeling is that over the next 20-year period, bonds could not even dream of the same kind of total return starting from a coupon that now squeaks in at 5%.
Joe Balestrino, lead manager of the $2.2 billion Federated Total Return Bond Fund in Pittsburgh, concedes this point, but also argues that, given the need of retiring baby boomers to preserve capital and get a guaranteed stream of income amid a possibly flagging stock market, bonds are far from a dinosaur asset class. He also believes that the only way to avoid the trip wires in this increasingly confusing market is to have a professional fund manager in charge.
"What's going on in the bond market-but what's not as appreciated as much as it will be-is that it is a much more difficult class to own on one's own," Balestrino says. "Right now, the bond market is overwhelmingly composed of mortgage-backed and corporates, and in the past it was Treasuries. And financial advisors are not in the business of picking individual corporates and mortgage-backed. They are in the business of growing the asset base. The bond asset class is a much more sophisticated landscape than ever before, because pure governments [Treasuries and agency debt] are only a third of the market today."
A Market That's Unyielding
Meanwhile, even after the subprime deluge has ebbed, the still-bad news on bonds is that their yields are achingly low, and financial advisors and portfolio managers have had to be cagey in finding extra juice, sometimes by slipping down to the riskier depths of the credit band where the tastier fruit awaits.
Interestingly, the subprime mess gave them more pickings. Berry says earlier in 2007, he heard from most managers that there was little opportunity to add value in the market. But then a lot of interesting things got washed up in the flood.
"Over the summer there was a lot of volatility in the bond market with subprime issues," he says, "and basically subprime influenced any bonds with even a hint of credit risk. And we saw a number of managers trying to take advantage of that volatility by scooping up mid-quality bonds or junk bonds, but also picking up some of the high-quality subprime securities." In other words, managers are finding babies that got thrown out with the bathwater.
"I would argue that relative to the spring, it's easier to get yield than it was six months ago because of the dislocations in the marketplace," says Matt Eagan, a co-portfolio manager of the $14 billion Loomis Sayles Bond Fund with Dan Fuss in Boston. "But globally, the reason [for the tight spreads] is that there is so much liquidity out there and not enough places to invest. That is driving down yields and leading people to take more risk than they would otherwise."
High-yield has been a particularly thorny area. Financial planners say that after many years of high-yield outperformance in this space, the current advantage of 400 basis points or so for investing in junk bonds just isn't worth the risk, especially if one thinks that corporate defaults (now at a very low count) will suddenly spike during an economic downturn.
"We [usually] have some low-quality debt under most market circumstances," says Matthew Chope, a CFP licensee with The Center for Financial Planning, a Raymond James affiliate in Southfield, Mich. "But we just moved away from that. It's rare that we move out of an entire segment, but we saw that yield spreads were at all-time lows at the beginning of the year and we've never seen such an anomaly."
Part of the problem with high yield now is its overabundance. Many companies trying shareholder-friendly initiatives-adding leverage through acquisitions or through buyouts-have contributed to a logjam in the junk bond market. "Suddenly, the appealing prices of those deals went out the window," says Shackelford. "It was more expensive to issue debt, and getting bondholders interested in buying your debt became harder because the market was in such turmoil and is still working off the supply overhang we've had in high yield over the summer."
Kate Scott, a CFP licensee and CPA with Cherry Hills Investment Advisors LLC in Greenwood Village, Colo., says her firm has also avoided junk bonds. For increased yield, she says she's been turning more to international investments through bond funds such as those offered by Loomis Sayles and PIMCO. She also likes Federal Home Loan Bank bonds. The 30-year was paying 5.125% as of October 30, she says.
For extra yield, municipal bonds are still very attractive, especially for people in high tax brackets. "On municipals, 7%-7.5% would be the taxable yield equivalent on a municipal that is double-tax exempt-no federal and no state tax," says Barbara Culver, a CFP licensee, with Resonate Inc. in Cincinnati. The yield on such municipals depends on the state, however. Culver also likes TIPS, which are designed to do well in times of rising inflation. Beyond that, she looks for yield in utility stocks or preferred stocks.
Hunt And Peck
Bond managers do a lot more than anticipate zigzagging interest rates. To outperform the market, they must make duration plays, bet on sector allocation, find yield curve strategies and ride other countries' currencies.
"We're trying to buy corporate bonds that will be upgraded over time," says Eagan of Loomis Sayles' fund. "We look for improving credit stories where positive credit momentum will dominate the return characteristics of the bond. They'll be less sensitive to market risk and interest rate risk." He says you can find those types of ideas in the high-yield corporate market, the emerging market and the convertible bond market. He gives as an example Boston Scientific, which was downgraded because of safety risks related to its drug-coated stents for clearing clogged arteries, but whose bond value later rose and offered temporary value. The Loomis Sayles fund also looks for a diversified basket of currencies, making large investments in Canada, New Zealand, Asia and Latin America, for example.
Shackelford, meanwhile, says that the T. Rowe Price fund has been looking at value in places such as in high-quality agency mortgages, which have recently offered investors a decent spread. He says late in the summer, current coupon agency pass-throughs were at about 6%.
"Sixes are traded above par and the yield-to-maturity in the generic 30-year pass-through market is 53?4, which is still an attractive level," he says, though he adds that the investor might have to live with volatility. "The mortgage market has been a victim of mortgage headlines. But we think that agency pass-throughs will continue to perform well."
Shackelford fears that the scary headlines in the asset-backed securities (credit-card backed securities, etc.) have also turned many people off the sector, but the market repriced itself after the summer and there are truffles that can be found. Until the summer, the investment-grade corporate bond