Although the market spotlight lately has favored equities, bond funds are still receiving inflows and remain popular, despite historic low interest rates and dark clouds on the horizon.

Bonds faced four strong years after the financial calamity in 2008, but fixed income today faces challenging conditions. For example, 10-year Treasurys are currently yielding less than 2%, close to the all-time low. Meanwhile, some bonds today are yielding at historic lows. Investors are concerned about safety issues following the recent financial travails suffered by Stockton, Calif., and other municipalities.

At a spirited press briefing in New York Wednesday, several veteran portfolio managers from Thornburg Investment Management discussed the challenges besetting the fixed-income market.

Jason Brady, managing director and head of taxable fixed income, gave an overview that didn’t prettify the problems facing investors. Brady is the portfolio manager or co-manager of four income taxable funds with laddered bond maturities of less than five years. He is also author of a recent book entitled Income Investing: An Intelligent Approach to Profiting from Bonds, Stocks, and Money Markets (McGraw-Hill).

“It’s been a tough environment for fixed income,” Brady said. “Investors have been looking for safety, and that option has been taken away.”

“The environment is challenging as the Fed [and, more broadly, global central bank] purchases continue to suppress yields on high-quality assets,” he explained. “This has led to additional, underappreciated risk given the change in risk/reward for those types of investments, as well as a revival of the ‘reach for yield’ trade. The typical rotation towards riskier assets has been on one hand accelerated by central bank action, and on the other restricted by a worse-than-usual investor experience in the last recession.”

In this environment, Brady said investors need to have a flexible understanding of risk and reward. “It’s not as simple as hiding in Treasurys anymore. The potential for loss in yield is still there. Yields can actually go lower,” he warned.

Privately held Thornburg, a moderate-sized asset manager based in Santa Fe, N.M., with roots dating back to 1982, manages $14 billion in taxable and municipal bonds. It offers six tax-exempt bond funds and three taxable bond funds. A 10^th fund, the Thornburg Investment Income Builder Fund (TIBAX), a combination bond-and-stock fund with $13.3 billion in assets, has been gaining popularity with advisors for its growing dividend outlays, Thornburg said.

Since inception in 2002, the fund has returned 11.34%. Brady manages the vehicle along with co-managers Brian McMahon and Ben Kirby.

Sensitive Munis

Municipal bonds in particular have been sensitive to changes. High demand has sent prices soaring and yields tumbling to record lows, said Chris Ryon, managing director and co-portfolio manager along with Josh Gonze of the Thornburg Municipal Bond unit.

Investors are not getting paid to take risk in the current muni market, Ryon said. “Muni bonds are overvalued,” he said. “Credit spreads are very narrow and investors are not getting paid much to purchase longer maturity securities. For example, real yield, meaning inflation-adjusted yield, in the last five years reflects what Ryon termed “the period of the new normal.”

During that period, he explained, investors were getting paid 1.3% above PCE (a Federal Reserve inflation measure). Today, by contrast, they’re paid 77 basis points, or 0.7% above the PCE, “so they’re not receiving much of a real yield.”

So why buy munis? They’re cheap relative to U.S. Treasurys as measured by the muni-to-Treasury ratio, which compares the yield of a triple-A muni to the yield on a Treasury, Ryon said.

He also said the high yield market in fixed income is currently overvalued. “It’s been full speed ahead there. People have continued to pile into the high yield market.”

Corporates Rule

By contrast, he said, Thornburg “continues to like corporate bonds. Corporate balance sheets are in great shape. They’re generating a lot of cash since the recession.”

Gonze also underscored the challenges, including compressed spreads and lower-than-normal yields, currently confronting muni investors and other fixed-income investors.

“Investors are keenly interested in generating income, so inflows into bond funds continue,” he said.

Thornburg, he said, “is focused mainly on the short end of the curve and higher quality bonds, so we are positioned to exploit any blip upward in interest rates or credit spreads,” Gonze continued.

“We have plenty of dry powder for when interest rates rise. At the same time, we’re sticking to a laddered discipline. We’re searching for underpriced bonds.”

“There are always one-off opportunities that represent anomalies, so we can still generate good returns, but not as much as in prior years,” Gonze added. “When we buy investments, we don’t buy a monolithic security called ‘the market’ or ‘the index’—we buy specific securities, and sometimes those securities are better than what one might guess by looking at broad index data.”

He said Thornburg continues to see value in health care, utilities and so-called “kicker bonds,” a special type of bond with a premium coupon and a short call date; it is indigenous only to the muni market.

Lon Erickson, a managing director and co-portfolio manager of the Thornburg Limited Term Income Fund (with $450 million in assets under management), warned investors away from debt issued by technology companies. “Tech changes occur rapidly and are difficult to forecast,” he said, using Apple’s recent stock slide as an example. “We don’t want to compound business risk with a lot of financial risk.”

What's A Bond Investor To Do?

Erickson had the following recommendations for investors in fixed income going forward:

First, investors should select investments with less risk. The firm recommends a time horizon of two to three years for securities.

Second, investors should stay diversified along different segments of the municipal yield curve. They should reduce risk by overweighting the less risky segments of the muni market.

Finally, he reminded investors of one of the main reasons they need fixed income as part of their portfolios -- to stay diversified by asset classes and to have asset classes with little or no correlation to equities.

In a brief Q&A period, Brady was asked what will happen when interest rates rise. “Dogs will be eating cats,” he quipped.