And Which Funds to Avoid
It’s the riskiest time in decades to be a bond investor. Many analysts say an ugly bear market in bonds already has begun. In the second half of 2016, the price of 10-year US Treasury bonds dropped 8% as yields soared from a record low of 1.37% in July to 2.45% in December. And US bond funds lost a whopping $18 billion in value within days after the presidential election over fears that Donald Trump’s economic stimulus plans will lead to much higher inflation that will erode bond values.
But fixed-income investment strategist Bob Brinker says it’s not a given that inflation and interest rates will soar and devastate the entire bond market. In fact, he believes bond funds still can play an important role in your portfolio. His take on which bond funds to favor—and which to avoid…
Shorter Maturities Are Key
The Federal Reserve expects to raise its benchmark interest rate three times in each of the next three years, reaching a range of 3% to 3.25%. This would cause many bond funds to suffer because bond prices tend to fall when interest rates rise. But as long as rates don’t rise very quickly, certain bond funds still can help cushion stock market downturns…provide decent yields…and perhaps even deliver some capital appreciation. The key is to keep your “durations” short. Duration, expressed in years, is a measure of how sensitive a bond fund is to changes in interest rates. A longer duration means that a fund is more sensitive.
These days, for any fund with a duration of seven years or greater, the yield on the fund is not worth the risk that rising interest rates will result in losses. With shorter-duration funds, losses in share price tend to be offset over time by rising yields. That’s because the fund’s bonds mature fairly rapidly…and the assets then are reinvested in new bonds at higher yields.
The wild card here is whether inflation will spike and, as a result, the Federal Reserve will be forced to raise interest rates more rapidly. That could lead to a mass exodus from bonds and big losses even in shorter-duration bond funds. But this is very unlikely.
I think the Trump stimulus package of big tax cuts and infrastructure spending will be scaled back by Congress. There will be enough stimulus to improve economic growth and keep stocks rising but not so much that it will lead to runaway inflation. Also, the strengthening US dollar will keep inflation down because many imports will be cheaper for consumers.
Bond Funds to Favor
The following four funds are likely to hold up much better than the overall bond market in a rising interest rate environment…
Vanguard Inflation-Protected Securities Fund (VIPSX). Unlike plain-vanilla US Treasury bonds, Treasury Inflation-Protected Securities (TIPS) typically do well in rising-rate environments because their yields adjust upward as inflation rises. Recent valuations of TIPS indicate that they are expected to provide a higher yield in the next five years than Treasuries with comparable maturities as long as the annual inflation rate over that period is 1.82% or higher. I expect 2%-to-3% annual inflation over that time. Recent yield: 0.06%. One-year performance: 4.8%. 10-year annualized performance: 4.3%.*
Fidelity Floating Rate High Income Fund (FFRHX). This fund invests in short-term, adjustable-rate loans that banks make to corporate borrowers. The yields typically reset every 30 to 90 days, so they keep pace with rising interest rates. Most floating-rate securities are rated below investment grade, which can raise the risk of the borrower defaulting on loan payments. But the Fidelity fund benefits from a deep research staff that looks for borrowers with solid-enough balance sheets. Recent yield: 2.9%. One-year performance: 10.5%. 10-year annualized performance: 3.9%.
Vanguard Convertible Securities Fund (VCVSX). Convertible bonds are an overlooked hybrid investment. They provide the protection of traditional bonds by offering fixed-interest payments and the return of your principal at maturity as long as the issuer doesn’t default. They also allow you to benefit from stock market gains because owners can exchange the bonds for a specific number of shares of the company’s common stock once the stock hits a specified price. Recent yield: 1.9%. One-year performance: 12.9%. 10-year annualized performance: 6%.
Osterweis Strategic Income Fund (OSTIX). Junk bonds are among my favorites for 2017. They have very attractive yields, and their default rates should stay low as the economy improves. Also, Trump is likely to loosen regulations on the energy and mining industries, two sectors that are common areas for junk-bond offerings, further helping to reduce defaults. The Osterweis fund, which takes on much less interest rate risk than its peers, has been keeping its duration around 1.5 years lately. Recent yield: 5.2%. One-year performance: 12.8%. 10-year annualized performance: 6.1%.
Bond Funds to Avoid
The following three types of bond funds face heightened risks in 2017. Some could suffer steep losses even in the face of modest interest rate hikes. Others could be hurt by changes in the tax code or a stronger US dollar. If you own funds such as these, consider selling…
Long-term government and corporate bond funds, plus any intermediate-term funds with durations of seven years or more. These funds are most likely to suffer losses. The Bloomberg Barclays Long US Treasury Index, with a duration of 17 years and a recent yield of just 2.4%, plunged 12% in the final three months of 2016, while the Barclays Long US Corporate Index dropped 5.7%.
Muni bond funds. The S&P National AMT-Free Municipal Bond Index tumbled 3.4% in the last three months of 2016. Muni bonds are vulnerable not just because of rising interest rates but also because of potential changes to the tax code under Trump and a Republican-controlled Congress. The changes, including a proposed reduction in the top tax rate on income to 33% from 39.6%, could diminish the value of muni bonds’ tax-free income for higher-income investors.
Foreign bond funds. Although bonds in many countries don’t face the risk of higher inflation or higher interest rates, the yields they offer are far lower than those of comparable US bonds. The S&P/Citigroup International Treasury Bond Ex-US Index had a recent yield of just 0.39% and lost 10% in three months. Emerging-market bond funds have much higher yields but more substantial risks. In particular, a strengthening US dollar hurts the value of these funds because they typically hold bonds that pay income in local currencies.
* Ten-year, one-year and three-month performance figures are through January 15, 2017.