Bonds are like that wolf in sheep's clothing-a seemingly benign investment whose teeth can come out with frightening ferocity when interest rates rise. Since the 1970s, when yields on long-term issues soared to almost 20% and sent bond prices into a freefall, many investors have had to learn that lesson through painful, often unexpected losses.
But shareholders of FPA New Income Fund have witnessed a more gentle version of the interest-rate beast. Since its inception in 1969, the fund has not had a single calendar year of negative returns. Robert Rodriguez, its manager since 1984, attributes the steady course of the fund during his tenure to a healthy fear of what the bond market can do.
As a young portfolio manager for private accounts in the 1970s and early 1980s, he saw interest-rate swings devour wealth for bondholders. When he took over New Income in 1984, he vowed to try to minimize bond losses because, in some ways, they are more caustic and lasting than losses from stocks.
"Stocks are much more heterogeneous than bonds," he says. "Some stocks can hit new highs, even if the broader markets are hitting new lows. But if the bond market is in a slump, you'll find few, if any, bonds that are doing well. So if you are wrong, and interest rates move against you, there aren't as many ways to dig yourself out of the problem."
Rodriguez tries to minimize interest-rate swings by investing in an eclectic group of fixed-income securities whose ups and downs offset each other. Using a "credit barbell" approach, he often mixes high-quality government or mortgage-backed bonds with carefully evaluated high-yielding junk bonds and busted convertibles, which are less sensitive to interest-rate fluctuations. The fund's duration is rarely longer than that of its benchmark, the Lehman Brothers Government/Credit Index. Right now, FPA New Income Fund's duration stands at a conservative 2.2 years, well under the 5.2-year duration of its benchmark.
Since 1997, Rodriguez also has made liberal use of Treasury Inflation Protection Securities (TIPS) to enhance performance and moderate volatility. The bonds, which currently make up 31% of the portfolio and about half his allocation toward government securities, have outperformed 10-year Treasury bonds since the fund began buying them. According to a study done by Tom Atteberry, an analyst who works with Rodriguez, the fund's TIPS produced an annualized return of 8.1% between June 30, 1997, and September 30, 2001, as opposed to 6.9% for 10-year comparative nominal Treasury bonds. They were also less volatile over the period.
Rodriguez's attention to moderating volatility has helped him produce an exceptional long-term record. As of February 18, the fund's performance landed it in the top 5% of its group over the last one-, three-, five- and 10-year periods. In its worst quarter, which occurred in 1987, it lost just 0.9% of its value, compared with 2.91% for the Lehman index. In 2001, the fund's 12.3% gain, compared with a return of 7.3% for the average fund in the group, prompted Morningstar to name Rodriguez its fixed-income manager of the year.
But there have been times, such as 1997 and 1998, when managers willing to make bolder interest-rate bets by extending their funds' durations came out ahead as rates fell. In those two years, FPA New Income finished in the bottom half of its peer group.
"We can't call every market cycle, and we don't think the rewards are high enough to risk being wrong," says Rodriguez. "To minimize losses, you have to be willing to lag for short periods."
He also acknowledges that some managers are better in bullish bond markets than he is. "Bill Gross at PIMCO is good at capturing the upside on bonds when interest rates are falling," he says. "Our relative strength shows when the bond market is neutral or down."
Preparing For A "Subdued" Recovery
Currently, Rodriguez has 62% of the fund in government securities. Half of that is in TIPS, with the balance invested in mortgage-backed securities. Although he is not adding to his TIPS position, he believes that they remain a good investment because their coupon, plus their anticipated principal appreciation because of inflation, is a better deal than the 4.92% yield currently available on traditional 10-year Treasury notes.
Over the last 10 months, Rodriguez has used cash inflows to beef up the junk bond and busted-convertible side of the portfolio in anticipation of an economic upturn in the second half of the year. These securities now represent 21% of assets, toward the high end of the fund's 2% to 25% historical allocation over the last 18 years. He also has been buying more interest-only (IO) strips, fixed-income vehicles that rise in value when interest rates go up.
Going forward, Rodriguez sees "an economic recovery already under way that will become more visible as we go through the year. However, this one will prove to be far more subdued compared to prior economic recoveries. The investment excesses of the late 1990s, especially in telecommunications and technology, haven't been wrung out yet. And consumers didn't get hit as hard as in previous recessions, so the spending rebound won't be as sharp."
Over the next five years, he expects the S&P 500 Index to generate returns of 5% or less because many stocks remain too richly valued, and earnings growth expectations are too high. "I think stocks and bonds will generate returns that are fairly close together," he says. "If you want to know which way I'm leaning, I'd have to give a marginal nod to equities."