Their Managers Are the New Bond Kings
Life is getting rocky for bond-fund investors. Rising interest rates are expected to drive down the value of many existing bonds. That could mean years of mediocre fund performance—and perhaps even losses—in a portion of your portfolio that is supposed to preserve assets. But fixed-income expert Bob Brinker says you can still make bond funds work for you.
Key for 2016 and beyond: Invest with the new Bond Kings—the managers who are deft enough to navigate the new rising-rate environment. We asked Brinker how investors should be positioning their bond-fund portfolios and which managers will stand out…
Choose the Least Vulnerable Categories
I expect short-term interest rates to rise slowly in 2016 to about 0.75%, up from near zero for most of 2015. Long-term rates likely will hit 2.8%, up from 2.2%. The result: The overall bond market is likely to see flat returns at best, and perhaps even losses if interest rates rise more quickly than I expect. However, you should be able to eke out total returns (yield plus capital appreciation) in the mid-single-digit percentages by taking some decisive actions…
• First, avoid areas of the bond world that are highly likely to struggle. Even a smart fund manager won’t be able to do much in short-term Treasuries, long-term Treasuries and foreign bond funds, which will continue to be hurt by the strengthening US dollar.
• Second, choose managers who focus on areas that are less likely to run into problems in a rising-rate environment and who have an excellent record of superior long-term returns…have outperformed their peers in past rising-rate environments…and have well-defined strategies for adapting to the uncertainty and elevated risk in bond markets today.
My Favorite Managers
The six managers below run funds that can serve as a diversified fixed-income portfolio in the coming years or can be used separately, depending upon your income needs and risk tolerance. The yields on these funds recently averaged 4%, and they had a modest duration averaging less than four years. (Duration, expressed in years, is a measure of how sensitive a bond or bond fund is to changes in interest rates—a longer duration means that it is more sensitive. For example, a four-year duration means a fund might suffer a 4% drop in net asset value if short-term rates rise by one percentage point.)
The best fund managers now…
Dana Emery, CFA
Dodge & Cox Income (DODIX)
Emery, the CEO and director of fixed income at Dodge and Cox, has run this fund since its launch in 1989. She and seven other comanagers use a plain-vanilla approach, buying undervalued intermediate-term corporate bonds that provide decent yields without the fund taking on a lot of interest rate or credit-quality risk. They execute this no-frills strategy with great consistency and charge much lower fees than most of their competition, which makes the fund a good core holding in a rising-rate environment. Recently, about one-third of the bonds in the portfolio had a credit rating of BBB, which is still considered investment-grade (high-quality), but not by much. Emery counterbalances these bonds with lower-risk government-guaranteed Ginnie Mae securities. Recent yield: 3.1%. 10-year performance: 5.2%.* DodgeAndCox.com
Jeffrey Gundlach
DoubleLine Total Return Bond (DLTNX)
Gundlach has been widely hailed as the best manager in fixed-income markets today, following the dethronement of former bond king Bill Gross (who was ousted from the giant Pimco Total Return Fund in 2014). Although such accolades could inflate a manager’s ego so much that he/she makes reckless bets, Gundlach’s five-year-old fund has been steady enough to be considered a core holding. His success is based on a unique expertise. Gundlach, who had a stellar record managing the TCW Total Return Fund for nearly 17 years until he left in 2009, invests in mortgage backed securities, bundles of residential mortgage loans that trade much like bonds. He uses a “barbell” approach, typically keeping one end of his portfolio in very stable, low-yielding mortgage securities that are backed by federal government agencies…and the other end in “non-agency” securities composed of riskier mortgage loans. Recent yield: 3.5%. Five-year performance: 5.3%. DoubleLine.com
Eric Mollenhauer, CFA
Fidelity Floating Rate High Income (FFRHX)
Mollenhauer’s strategy benefits from rising rates. He specializes in bondlike securities known as bank loans. These loans, made by banks to companies with junk bond–quality credit ratings, were recently yielding 4% to 5%. That may not seem like much compensation for the risk, and bank-loan funds have struggled in recent years. But there’s a twist—bank-loan “coupons,” which determine the yield, are not fixed as most bonds are. They can adjust every 30 to 90 days, which means that they go up if short-term rates rise. Mollenhauer focuses on loans made to companies with credit ratings of BB, the highest credit tier for junk bonds. He also prefers owning loans made to big companies that generate lots of cash flow, which improves their ability to pay the interest on their debts. Recent yield: 4.7%. Performance: 3.7%. Fidelity.com
Dan Fuss, CFA
Loomis Sayles Bond (LSBRX)
Fuss, who has managed this multisector fund for nearly 25 years, once managed the investment portfolio for Yale University’s endowment. He can choose almost any type of fixed-income investments anywhere in the world for the fund. He hunts for securities that are deeply undervalued and have a great potential for strong appreciation, often due to a likely upgrade in credit ratings—a contrarian style that works especially well in volatile bond markets. Lately he has found value in the lowest tier of investment-grade bonds (BBB) issued by metal and mining companies. He also keeps about 10% of his fund’s assets in Canadian bonds. This eclectic fund requires patience and a long-term perspective because Fuss’s performance often trails the broad bond market for a while before dramatically outperforming it over the long term. Recent yield: 3.7%. Performance: 6.1%. LoomisSayles.com
Carl Kaufman
Osterweis Strategic Income (OSTIX)
If you can handle significant volatility, high-yield (junk) bonds can provide attractive returns even as interest rates rise. That’s because a healthy, growing economy, which is likely for the next several years, tends to keep down default rates on junk bonds. Kaufman brings an unusual spin to this category. He holds a portfolio of about 90 junk bonds with a short average duration, recently just 1.9 years. That means that even if interest rates were to spike a few percentage points in the next year, his fund still could deliver a positive return. Where Kaufman has really excelled, however, is in managing credit risk. Since the fund’s inception in 2002, no bonds in his fund have experienced a default. He especially likes CCC-rated bonds issued by companies with improving balance sheets. These bonds often are ignored because they are too risky for most investors and many institutions aren’t allowed to own such low-rated debt. Recent yield: 5.9%. Performance: 6.1%. Osterweis.com
Mark Sommer, CFA
Fidelity Intermediate Municipal Income (FLTMX)
Conservative investors can benefit from Sommer’s approach to bonds that are issued by cities, states and certain private entities such as hospitals. The fund, which is exempt from federal tax, recently had a 4.9-year duration and a 1.5% yield, which may not seem exciting but is equivalent to 2.5% for a taxable bond fund if you are in the highest tax bracket. That’s also attractive compared with the recent 1.7% yield on a five-year US Treasury bond. I also expect Sommer’s bond picks, selected with the help of Fidelity’s large analyst team, to produce some capital appreciation in 2016 because a number of his holdings are likely to see credit upgrades. The Fidelity fund’s portfolio is heavily invested in health-care revenue bonds, which will benefit from the Affordable Care Act and national health-care reforms, and also in general-obligation bonds from states with improving balance sheets, such as Florida. Recent yield: 1.5%. Performance: 4.1%. Fidelity.com
*Performance figures are annualized returns for the 10 years through December 9, 2015, unless otherwise noted.
