INSIGHTS

On April 02, 2012

Bond Investors Beware: Quicksand Ahead

There is a potential danger out there lurking for bond investors who are anxious for interest rates to increase.  That danger for these yield-seekers is getting stuck in a bond mutual fund that might never deliver an investor the opportunity to realize the return of their capital.  Bond mutual funds have been the beneficiary of a huge outflow of funds from the equity markets in 2011.  The trend continued through the first quarter of 2012 even as equity markets turned in one of the best quarterly performances in a decade.  Why wouldn’t investors continue to throw in money?  They have been good performers over the past few decades as the tailwinds of lower interest rates drove total returns.  What these investors might be missing is that given the “mutual” nature of a mutual fund, they don’t have the privilege of a maturity date where they can choose to reinvest their principal. 

Interest rates continue to plod along at generational lows, leaving investors to stretch for yield and income.  Interest rates have been steadily dropping for the past 30 years as inflation drifted lower, giving way to recent spurts of deflation.  The result was a generation of higher bond prices and lower yields.  Mutual funds were an easy way for individual investors to gain access to yield with professional management.  These funds pool investors’ capital and invest in a portfolio of bonds.  Interest is paid out but capital is reinvested in new bonds.  Being an investor whose capital is pooled with others was a great place to be as prices rose but might be a real stinker when prices begin the inevitable decline.  Mind you, we are not trying to trounce these funds, just simply point out some structural challenges that might await their investors.

Bondholders have always faced just two major risks trying to manage a portfolio of bonds.  The first is credit risk, or the risk that the issuer will successfully make the principal and interest payments due on a timely basis.  This risk is measured by a bond’s rating; the higher the bond’s credit rating, the lower the perceived credit risk. 

The second is interest rate risk, or the risk that the principal value of a bond portfolio will fluctuate up or down as interest rates move.  That risk is measured by the portfolio’s duration; the lower a portfolio’s duration number, the lower the risk to interest rate movement.  Many investors pay little attention to duration risk as it is of little consequence when prices continually rise over a long period.  Duration risk is very real and can devastate a portfolio quickly.  An example of this risk would be a buyer of a 10-year Treasury bond today yielding 1.64%.  If interest rates move just 1% higher, that investor would suffer a 9% drop in their principal value.   A return to more normal yields would likely entail a much higher jump in rates and larger loss in principal value.

Duration risk declines as a bond gets closer to maturity.  Many investors believe that even if rates rise, they would be able to hold their bond to maturity and eventually get their principal back.  This is the logic of a bond ladder where each year one “rung” matures and can be re-deployed at higher rates.  Mutual fund holders do not have this luxury because there is never an individual maturity date for a holder.  Because the bonds are pooled, there is no individual ability to ever recognize a maturity at par.  Given there is never a maturity date, we refer to this as “perpetual duration.”

The reason duration risk is relevant now is that we are approaching the final days of the secular bull market in bonds.  Interest rates have hit historic lows and are very close to zero.  The Federal Reserve (“Fed”) is engaged in purchasing longer dated Treasuries in an effort to lower rates.  In the process, they are also driving up prices for longer dated bonds.  The Fed is doing this to try to raise inflation expectations and fight deflationary forces.  They are driving funds to risk assets as returns in the Treasury market are all but gone.  A recovering economy would bode well for higher rates as credit demand increases.  We would always advocate not fighting the Fed.  We believe that they will eventually be successful in creating inflation and thus take their foot off the easy monetary gas pedal.  If that happens, there is a high likelihood that interest rates will rise and duration risk will become a very powerful force to deal with.  We remind readers that most advisors have only experienced the secular bull market in bonds and have no experience in managing through a secular bear market.  This was the same observation made of the industry at the end of the last century when the secular bull market in equities was topping out.  The end was not pretty.

If rates do begin to move higher, it will be vital to control interest rate risk in bond portfolios.  It will be critical for individuals to be able to have a defined due date for principal and not be mixed in with thousands of other “mutual” investors.  Effective bond portfolio management requires the ability to move the yield of the portfolio higher over time as lower yielding bonds roll off. 

Why are bond mutual funds so challenged in times of rising rates?  Beyond the lack of a maturity date for the individual, there is also pressure on the portfolio manager as investors respond to dropping principal values by redeeming shares.  This requires the manager to sell bonds to meet the redemptions. Our experience has shown that during times of interest rate shocks, mutual funds too often cut income distributions as they are being forced to liquidate their highest yielding bonds.  Could it be possible that the fund’s income distribution would drop as rates rise?  It has happened, and I would point investors to the brief 1993-1994 cyclical downturn in bond prices.  This is the quicksand that may likely trap bond fund holders as losses couple with lower distributions just when the markets begin to offer higher yields.

At the end of the day, the bond investor might be better served to concentrate on owning the individual bonds or a vehicle such as a Unit Investment Trust (UIT), where the portfolio is fixed and maturities give the investor the chance to reinvest the proceeds at higher rates. UITs are a professionally-selected portfolio of bonds that do not change during the life of the trust.  The portfolio is monitored by the sponsor and securities may be sold if the bond were to cease to be appropriate to hold.  Overall, UITs provide permanence and definition to a bondholder’s portfolio, having a yield that will not fluctuate due to portfolio “management” and returns principal at par to clients as the bonds come due.  This structure allows for the portfolio duration to shorten as the bonds approach maturity. 

Bond mutual funds have performed well over the past 30 years as bond prices have raised steadily.  We believe that we are close to the end of the secular bull market as rates approach zero.  Bond fund managers will be challenged in the pooled funds to react to higher prices, lower yields and redemptions.  Bond investors might wish to consider individual bonds or UITs that allow investors to realize their principal back even if rates rise.  For those investors who ignore the risk it might truly feel like quicksand – stuck waiting to recover their principal.

Advisors Asset Management is a sponsor of Unit Investment Trusts.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com