Bond funds could be on borrowed time
CHICAGO (MarketWatch) -- In a world where financial rescues dominate headlines, U.S. government bond funds played hero yet again, rescuing portfolios in a tough second quarter.
Sound familiar? Analysts have been pegging the end of the decades-long (and surely stretched?) Treasury rally ad nauseam. But Europe's festering credit crisis, weakening Chinese economic growth, and a bumpy U.S. recovery combine to pressure the Federal Reserve and its counterparts to hold interest rates at extraordinarily low levels.
At least, that's what the central banks tell us. Those banks are proving to be steady Treasury customers, sticking to longer-term debt purchases to depress longer-term interest rates.
Central bank demand, and that of investors looking for shelter at any cost from global volatility, has plumped up bond fund returns. Long-term bond funds rose 3.4% for the 13 weeks through June, according to preliminary data from investment researcher Morningstar, Inc. They're up some 13.5% over the past year.
Long government funds clobbered all fixed-income categories in the period, up 10.3% and 35.6% over the past year. The gain compares to quarterly losses of some 3%-6% for midcap and large-cap stock funds of varying styles. Meanwhile, short- and intermediate-dated government bond funds rose 0.5% and 1.6%, respectively, in the quarter. Read more: It's 'duck' season for U.S. stock fund investors.
For much of the world, Treasurys are a lifeline that's filling an insurance role in portfolios, but it's an expensive policy. And it's too rich as a pure investment play just now, said Steve Walsh, chief investment officer of Western Asset Management Co. Walsh spoke during a Morningstar Investment Conference panel in late June.
But should investors fight the Fed?
"It's a tough conversation. Most see only the old world [of fixed-income investing] where rates go lower and total return goes up when equities are down," said Jeffrey Rosenberg, chief investment strategist for fixed income at BlackRock Inc.
"There's some complacency setting in, the thought that, I'll do what I've always done and be rewarded for it. You have ask, how much longer can this way of investing continue to deliver the way that it has delivered in the past?" Rosenberg added. "We've not had in 40-50 years interest rates across the curve that are below the inflation rate."
For most observers, that means interest rates have only one direction to go -- up. The prospect of higher rates puts emphasis on being forewarned and forearmed.
"We are at the foothills of a long rise in interest rates," said Dan Fuss, co-manager of Loomis Sayles Bond Fund (LSBRX) , also a participant at the Morningstar conference.
"History tells us when you have a longer period of central bank buying, you have the potential for money supply to start to grow and things to get a little bit out of hand," Fuss said. "When do foothills become mountains? I don't know. But I don't want to read about it after the fact."
While U.S. Treasury securities offer safety with regard to default risk, they will suffer principal losses in a rising interest rate environment. In the "old world," fixed-income managers and investors were focused almost exclusively on balancing interest-rate risk.
"Now, attention should be on credit conditions, a far less shaky prospect than trying to position for interest-rate risk," BlackRock's Rosenberg said.
With traditional "benchmark" fixed-income portfolios currently providing negative yields after inflation, Rosenberg advised investors to consider increasing allocations to fixed income sectors with better inflation resiliency including floating rate loans (bank loans) and high-yield.
High-yield funds failed to impress in the June quarter, up 1.2%. Higher-rated multisector corporate bond funds were up 1%, according to Morningstar data; they're up 4.8% over the past year.
As for tax-exempt offerings, high-yield muni funds logged around a 3.2% gain, padding their 13.8% one-year return. National long-dated muni portfolios were up 2.1% in the 13-week period and 11% over the past year.
Elsewhere, in the "riskier" space, emerging-market bond funds finished the quarter flat, trimming their one-year gain to 3.4%. World bond funds eked out a 0.4% quarterly return, and were up 2.4% over one year.
Risk is relative
The globe's fiscal volatility has amped up the attention on emerging markets in recent months, and that's not likely to change soon.
"There's a better balance sheet story and a better growth story in emerging-market (compared to the developed world) and a better fiscal outlook," said Penny Foley, portfolio manager for TCW Emerging Market Strategies, including its TCW Emerging Markets Income Fund (TGINX) , while on the Morningstar panel. "I don't see the debt-to-GDP ratio [that favors emerging markets] changing until at the least the middle of this decade."
Brian Rehling, chief fixed-income strategist at Wells Fargo Advisors, agreed. "We continue to recommend an overweight to emerging-market debt as we believe yields and valuations remain very attractive relative to other fixed-income asset classes," he said.
Emerging-markets bond funds are also cheaper than their stock-fund rivals and have provided handsome returns, according to Morningstar senior mutual fund analyst William Rocco, in a commentary. The median no-load fund in the emerging-markets bond category has an expense ratio of 1.07%, while the median front-load offering in that group has an expense ratio of 1.25%. Although those expense ratios are high relative to other fixed-income offerings, they compare quite favorably to those of emerging-markets equity offerings.
"Emerging-markets bond funds are no slouches when it comes to upside potential," Rocco noted. "They've climbed 30% or more in 23 rolling 12-month periods over the past 15 years."
Indeed, the developed world isn't getting any younger and investors' hunt for lower-risk, income-generating opportunities will only increase. That keeps pressure on fund managers. Should they accept this new fixed-income world of higher-risk, lower-rates and strategically move about within this new scenario -- even if that means short-term pain (remember, fighting the Fed has been a losing proposition of late)?
Says Pimco's Bill Gross, in his latest monthly column: "Don't underweight Uncle Sam in a debt crisis. Money seeking a safe haven will find it in America's deep and liquid (almost Aaa rated) bond and equity markets.
The U.S., he noted, is the "cleanest" of a world of "dirty shirts."
"Yet there may come a time," Gross wrote, "when the king adorned in his clean dirty shirt may be redressed or perhaps undressed to reveal he has no clothes -- just like Greece – just like many or most of the rest of them."
The best managers have more than one shirt in their closet -- one, an admittedly expensive Treasury design, and another with a little padding against inflation, whenever it should arrive.