Are Bonds Still Safe?

All eyes are on bonds these days. Seeking safety, investors poured money into bonds and bond funds. That lowered interest rates, generated capital gains, and attracted more investors to bonds.

As treasury yields approached 40-year lows, yield chasers turned to high yield and corporate bond funds. Mutual funds attracted $11.8 billion of investments in March. High yield bond funds received $4.6 billion of that money, and $8.8 billion in the first three months of the year. That compares with $4.9 billion for 2002. Corporate bonds also attracted a lot of money.

We’ve been major beneficiaries of this trend as all our portfolios took early positions in high yield and corporate bonds. These bonds are bargains no longer, but I expect them to continue doing well for at least a few more months as the economy strengthens. The spreads between treasury bond rates and corporate and high yield bond rates will continue to narrow from their historic levels of 2002.

I’m not optimistic about treasury bonds and, to a lesser extent, mortgage bonds such as GNMAs. Yields should rise as the economy improves and inflation increases a bit. That will cause bond values to fall. You can see how much your bonds might lose by using the calculator at www.smartmoney.com/bonds/ and clicking on the Bond Calculator.

If you have core holdings in treasuries and GNMAs you want to protect without selling, there is another move to consider.  Your bond portfolio can be hedged against rising rates using mutual funds. Rydex Juno and ProFunds Rising Rate Opportunity funds sell short the 30-year treasury bond, gaining value when interest rates rise. The ProFunds offering uses leverage to return 125% of the inverse of the long bond’s return. Minimum investments are $25,000 and $15,000, respectively.

For example, if you have a $500,000 bond portfolio that has a duration of five years, it will lose 5% if the 30-year treasury yield rises 1%. Add a $50,000 position in Rydex Juno and the net loss will be only 3.2%.

You don’t want to hold these funds permanently. They are only for when you expect interest rates to rise and do not want to incur the capital gains taxes and fees of selling the bond portfolio.

Sector and Balanced Portfolios

Investment markets are in a sweet spot when almost all the funds in a diversified portfolio rise. We are very close to such a sweet spot.

Leading our Managed Portfolios, and the markets, is TCW Galileo Select Equity. In rising markets this outstanding growth fund almost always seems to hold leading stocks. The concentrated portfolio usually holds about 30 stocks and makes few changes over time. It will fall almost as sharply if the markets turn, so keep a watch on the sell signal. As long as growth stocks are in a bull market, though, we want to give this fund room to make our portfolios increase.

Hussman Strategic Growth recently decided that market conditions are favorable and removed most of its hedge. The hedge, designed to protect the fund in market declines, can cause the fund to lag the indexes in rising markets. Yet the fund generated positive returns and rapidly is catching up to the indexes.

AXA Rosenberg Global Long/Short Equity always has some short positions. These positions caused a small decline in the fund as the markets improved. I recommend keeping the fund as a good hedge against a volatile and uncertain market.

Cohen & Steers Realty Shares is doing well again, as investors apparently take a more optimistic view on the economy.

While lagging the stock indexes in the past month, all our bond positions are showing positive and strong returns. American Century International Bond, after almost hitting a sell signal in March, bounced back strongly to return over 5% in the last month.

In the last couple of months we would have had higher returns with an all-growth stock portfolio. We use diversification and sell signals to protect us from all the uncertainty out there. They help us earn solid returns and protect ourselves from the possibility of steep losses.

Hold all your positions and watch the sell signals.

Income Growth

The Core Portfolio recently generated outstanding returns. Events in the Middle East plus a perception of a worldwide natural gas shortage have helped the utility funds, FBR American Gas Index and American Century Utilities Income. Their returns rival those of growth stocks since the market bottom in October 2002. At some point I probably will recommend diversifying the Core Portfolio a bit, because the utility sector became more volatile in recent years. For now, we’ll ride this wave of growth that also pays high income.

The Managed Portfolio continues to provide capital gains with solid income. Hold all the positions and follow the sell signals.

Income

Our Managed Portfolio remains well-positioned for current conditions in the debt markets. This month, the Core Portfolio needs attention from some of you.

My long-time Core Portfolio has been 100% in PIMCO Total Return D. I’ve included bond index funds, such as Vanguard Total Bond Index, as alternatives. In the last year or two bond index funds, especially Vanguard’s, have lagged the bond indexes. Unlike a stock index fund, a bond index fund must make choices from the thousands of bonds in the index. The managers have not done this well.

In addition, index funds have to hold a lot of treasury bonds and GNMAs. I expect these sectors will incur losses in the face of rising interest rates in the next few years. Managed funds, such as PIMCO’s, can reduce their treasury and mortgage holdings. For these reasons, I recommend that index fund owners consider seeking out either a managed fund for their Core holding or moving to a shorter-term bond index fund.

Also, owners of PIMCO Total Return should know that they get the same manager at a lower cost by purchasing Fremont Bond. Over time, Fremont Bond has had a slightly higher return than PIMCO’s because of the lower fees. Another good alternative is Price Spectrum Income. It holds a diversified portfolio of Price’s active bond funds, including high yield, corporate, international, and emerging market funds. The allocation won’t change as it will for the PIMCO and Fremont funds. The long-term record has been quite good. Sometimes it beats the Fremont fund, at other time it doesn’t. Current yield is between 4% and 5%.