(And the Funds to Avoid)
Will US interest rates ever start to rise? Of course they will, although investors and analysts were surprised for much of last year that rates kept dropping. That was good news for fixed-income investors as bond prices—which move in the opposite direction of rates—chalked up healthy gains. Funds that track the total bond market rose 6% in 2014.
But a sharp or prolonged increase in interest rates could cause bond prices to sink, hurting many fixed-income investors. That threat has grown as the Federal Reserve prepares to start pushing up short-term interest rates.
Bottom Line/Personal asked leading bond-fund strategist Robert M. Brinker to discuss the outlook for bonds—and to identify which bond funds are likely to do well and which to avoid…
DON’T CHASE HIGH YIELDS
The good news is, this year is likely to be OK for bond funds. But I don’t expect it to be as good as last year. Reasons for the mildly positive outlook: The economy is stable and growing modestly…inflation will remain tame…and defaults on debt should remain low by historical standards. Any rise in interest rates likely will be gradual and measured, not sharp enough to cause a meltdown in bond prices.
However, I do expect the Federal Reserve to finally raise the federal funds rate (the key factor influencing short-term interest rates) by one-quarter to one-half percentage point by the end of 2015. Long-term rates are likely to bounce up and down in a narrow range, with the yield on the 10-year Treasury fluctuating between 2% and 3%.
This scenario doesn’t mean that you should be taking big risks now such as chasing high yields or betting on the timing of interest rate hikes. Many bond asset classes, ranging from 10-year Treasuries to high-yield (junk) bonds, are pricey after substantial gains in recent years, making them vulnerable to quick sell-offs. Also, we’re likely to see enormous ups and downs in bond prices as the Fed gets close to actually raising rates. You still can get a decent total return and control volatility by owning bond funds with durations of eight years or less (duration is a measure of bond sensitivity to interest rate fluctuations) and concentrate on areas of the bond market that still are reasonably priced.
BOND FUNDS TO AVOID
The following six types of bond funds are unappealing this year. Some will suffer disproportionately if interest rates rise more quickly than expected…and others are simply overpriced and unlikely to produce much total return.
Short-term government bond funds and short-term high-quality corporate bond funds. It will continue to be difficult to earn a safe, predictable return in these funds. Even if short-term interest rates do rise a bit, the yields on high-quality bond funds will take a while to reflect those increases. The Barclays US Treasury 1-3 Year Bond Index had a recent annual yield of just 0.35% and rose just 0.6% in 2014. Conservative savers will be better off in top FDIC-insured savings accounts, which pay as much as 1.25% and will keep pace with any short-term interest rate hikes.
Long-term government bond funds and high-quality corporate bond funds. These funds soared 22% in 2014, outperforming every other bond category. But they also were among the worst performers back in 2013 and 2009. The volatility comes from their extreme interest rate sensitivity. As soon as rates rise even a little, investors can buy new bonds with higher yields, which pushes down the value of the older, lower-yielding bonds. I’m taking reasonable precautions against that possibility by keeping the duration on all my bond funds at eight years or less. Even if interest rates remain steady in 2015, the recent yield on long-term bond funds (about 2.8%) isn’t worth the risk of holding them.
Floating-rate (bank-loan) funds. These funds buy relatively risky loans made to companies with junk-bond credit ratings. They can be attractive to investors in rising interest rate environments because the loans don’t have fixed yields as junk bonds do—they adjust every 30 to 90 days. The problem: These funds have become so popular that investors have inflated the prices of the bank loans and caused the yields to shrink. The average bank-loan fund had about a 4% yield in 2014 but, overall, gave investors a total return of less than 2% because of price drops.
High-yield (junk) bond funds. These funds can do well in stable economies and are less sensitive to interest rate hikes than most other bonds, but they pose specific dangers in 2015. Many junk-bond funds have heavy exposure to bonds of energy companies, which could increasingly suffer defaults if oil prices remain low. Also, several years of rising prices have pushed down the yields on junk-bond funds. Historically, that yield needs to be at least five percentage points higher than the yield on 10-year Treasury bonds to adequately compensate for the risks that you are taking. Recently, the spread in yields was only about three percentage points.
BOND FUNDS TO FAVOR
These funds, both no-load (commission-free), look attractive for 2015…
DoubleLine Total Return Bond Fund (DLTNX). Intermediate-term bond funds with durations between three and 10 years form the core of fixed-income portfolios for many investors. They returned an average of 5% in 2014 and could be in a sweet spot in 2015, offering decent yields and returns while taking moderate interest rate and credit-quality risks. The DoubleLine fund is run by Jeffrey Gundlach, perhaps the best manager in fixed-income markets today. Gundlach, who launched DoubleLine LLC in 2009 and has seen it grow to more than $50 billion in managed assets, invests primarily in bargain-priced, mortgage-backed securities, which are bonds composed of large bundles of residential mortgage loans. Continued US economic growth should help boost personal incomes and housing prices, which will benefit the investments this fund makes. It recently yielded 3.7% with an average duration of 3.24 years and a BB average credit quality. Three-year annualized performance: 5%. DoubleLine.com
Note: More risk-averse investors can opt for a tamer version of the DoubleLine Total Return Bond Fund called the DoubleLine Core Fixed Income Fund (DLFNX). It uses a similar strategy but keeps about one-third of its portfolio in intermediate-term high-quality government and corporate bonds. Three-year annualized performance: 4.3%.
Loomis Sayles Bond Fund (LSBRX). Multisector funds can invest in almost any type of bond, regardless of the length of maturity, credit quality, type of issuer or country. That allows a talented manager to venture into the most undervalued areas of the bond market. This fund, run by Loomis Sayles vice chairman Dan Fuss for nearly 25 years, rewarded investors with a 4.5% return in 2014. Fuss is finding some of his best opportunities overseas, where bond prices have sunk under the weight of faltering economic recoveries in Japan and Europe. Five-year annualized performance: 8.2%. LoomisSayles.com
If You’re in a High Tax Bracket…
For investors in upper-income tax brackets, the following tax-exempt fund may be attractive.
Vanguard Intermediate-Term Tax-Exempt Fund (VWITX). Municipal bonds, issued by state and local governments and typically exempt from federal income tax, bounced back last year. Muni bond funds averaged a 9% return in 2014 as memories of major municipal defaults such as Detroit’s bankruptcy faded. I expect the muni rally to continue in 2015. The improving US economy continues to strengthen the balance sheets of many state and local governments. This fund has some of the lowest expenses in its category, the most diversified portfolio (more than 4,000 bonds) and recently yielded 1.6%, which is a tax-equivalent yield of 2.22% for taxpayers in the 28% federal tax bracket and 2.39% for those in the 33% bracket. Its average duration of 4.8 years will help keep share prices relatively stable if interest rates rise. Five-year annualized performance: 4.5%. Vanguard.com
Smart: If you prefer individual muni bonds, two states—California and Massachusetts—allow anyone to buy them directly online, similar to the way US Treasuries can be purchased. You save on brokerage fees and/or commissions, and for residents of those states, the yield is exempt from that state’s income tax as well as federal tax.
