How to navigate the bond rout

December 16, 2010: 5:00 AM ET

A flood of money into fixed income drove once-stable bonds into bubble territory before starting to retreat this month. Here's how to adjust your strategy and protect your portfolio.

For generations, bonds have offered investors a safe haven that provides both steady income and far more stable prices than mercurial, zigzagging stocks. But lately, bonds have been doing the zigzagging, threatening the very qualities that make fixed income so attractive.

The financial crisis sparked a buying frenzy in fixed income that has only started to abate. Since September of 2008, investors have poured a total of $937 billion into bond funds -- increasing the total investment in those funds by 55% and dwarfing the $195 billion that flowed into stock funds over the same period.

This flood of money inflated bond prices to such heights that it drove yields -- interest payments divided by bonds' market prices -- to their lowest level in 50 years. Because a bond's interest payment is fixed, the higher its price goes, the lower its yield becomes.

But now there are signs that the great bond bull market may be coming to an end. News last week that President Obama reached a tax deal with congressional Republicans pushed bond prices down and sent yields surging. By Tuesday, yields on the 10-year Treasury bond had jumped to 3.27%, up from a low of 2.33% in October.

How much will this recent market swoon hurt fixed income investors? Whether bonds will suffer the same fate as real estate and tech stocks is still highly uncertain. Former Treasury Secretary Robert Rubin has predicted a disastrous rout, and Warren Buffett recently warned about "the overextended bull market in fixed income." In November, Bill Gross, the founder of Pimco, one of the world's largest managers of fixed-income mutual funds, called an end to the 30-year golden age that gave bond investors near-double-digit returns.

What is clear is that many fixed-income products that were great investments in the past are still extremely vulnerable to steep declines in price. That's a crucial shift that will require many Americans to rethink their strategies. We'll help you achieve the right mix -- starting with the principle that bonds are still essential. All investors, and especially Americans nearing retirement, need to place a big portion of their nest egg in fixed income to gain steady payouts and provide a balance for the volatility of stocks. But more than ever, they must play it safe by carefully picking bonds that offer both decent returns and protection from big capital losses.

Achieving that goal will require a wide-ranging, discriminating choice of investments. "What we know for sure is that most bonds aren't paying you enough in yield today to compensate for their risk," says Chris Brightman of Research Affiliates, an investment firm that oversees strategies used in managing some $60 billion. "The solution is for people to learn about and invest in products and parts of the world they probably never chose before."

But before you design your bond approach, it's important to understand why yields went so low -- and why they couldn't stay there for long. Let's start with Treasuries. Government bonds are not only the most popular fixed-income investment, but they also heavily influence rates on all corporate bonds. The yields on Treasuries are composed of two building blocks. The first is the "inflation premium." It represents investors' forecast of the future rise in prices of things like rent and groceries. But bondholders aren't satisfied by just staying even with inflation. They demand an extra return.

That's the second component of bond yields: the "real" return, which typically reflects economic growth. The real rate reflects demand for capital and closely follows growth in GDP -- it rises in recoveries, when companies borrow heavily to expand, and wanes in recessions. How about corporate bonds? Yields on corporates are higher than on comparable Treasuries because they contain a third component -- a "credit" spread. The riskier the security -- the bigger the chance the company will default or be downgraded -- the wider the spread. Witness the fat rates on junk bonds.

The reason bonds became so dangerous is that the ultra-low yields on Treasuries reflected neither a reasonable real rate nor an adequate allowance for future inflation. So what kept Treasury prices high and yields artificially depressed? The answer is twofold. First, during the past decade there have been a pair of wrenching shocks in equities -- the tech-stock meltdown of 2001 and the crash of 2008. Both U.S. and foreign investors fled to the safety of Treasuries during the Great Recession, and they're still wary of stocks.

The second factor is the extraordinary actions of the Federal Reserve. The Fed is using its immense powers to hold down yields on both short- and long-term Treasuries. "There's an artificial buyer in the marketplace, so it's hard to gauge the true value of Treasuries," says Elaine Stokes, a portfolio manager for mutual fund giant Loomis Sayles. The Fed is restraining the short end by keeping the Fed funds rate near zero. And starting in November, chairman Ben Bernanke launched a quantitative easing campaign, known as QE2, to lower already paltry yields on 10- and 30-year Treasuries by purchasing $600 billion in longer-term bonds. The goal: Hold down mortgage rates to aid a housing recovery, and keep credit cheap for consumers and companies to spur the weak economy and boost employment.

The problem is that neither the public's infatuation with bonds nor the Fed's epic stimulus will last Investors have already become dissatisfied with puny yields. And QE2 can't go on forever. Once the economy rebounds, the Fed will need to stop buying long-term bonds and substantially raise the Fed funds rate. That's the pattern in every recovery, and it will happen again. Recall that in early 2008, before the credit crisis, the Fed funds rate stood at 4.25%. It's now 0.25%.

Once these special forces recede, the factors that always determine bond yields -- growth and inflation -- will once again take hold. For investors, the biggest risks are in longer-term bonds. Over the past 60 years, GDP growth, which drives real rates, has averaged 3.3% and inflation almost 4%. Longer-term Treasuries generally yield about the sum of those two numbers, plus a premium for the risk of committing your money, at fixed rates, for a number of years. Hence, the 50-year average yield is 6.76% for 10-year Treasuries and 7.2% for the 30-year. Right now, even after the recent decline in bond prices, the 10-year yields a mere 3.8% and the 30-year a measly 4.5%.

Of course, we don't know when, or even if, rates will return to their historical averages. But it's reasonable and prudent to bet that yields will eventually approach those long-term levels. To be conservative, let's assume that it won't happen for two full years, until early 2013. How big will an investor's loss be in long-term Treasuries over that span?

The short answer is: enormous. To fully gauge the size of the risk, consider the concept of "duration." Put simply, duration measures the change in a bond's price caused by a change in interest rates on similar bonds. The biggest factor in determining duration is the length, or maturity, of the bond. Remember that Treasuries, and most other bonds, pay back all of your original investment upon maturity. But if rates on similar, newly issued bonds rise, the price of the long-term bonds you're holding will drop. The longer the maturity, the steeper the drop. Meanwhile you're stuck with a puny, below-market yield and a bond selling for far less than the price you paid.

With any long-term bond, duration takes on immense importance. That's because right now rates have loads of room to rise. "When rates are this low, you have tremendous risk they will rise, and rise quickly," says Rob Williams, director of fixed-income planning at Charles Schwab. Look at 10-year Treasuries. The duration is almost nine, meaning the price will drop 9% for a one-point rise in rates on new 10-years. So let's assume you buy the bond today, and that yields return to their half-century average of 6.76% by 2013. The price would drop by 26% -- wiping out your income return and more. The math gets far worse for 30-year bonds (see table above).

That's why investors are better off shunning long-term Treasuries. They should focus on bonds with relatively short maturities and invest in new corners of the fixed-income market. Rather than individual bonds, we recommend that investors buying funds stay well diversified and keep expenses relatively low. The best deals fall into four categories:

Intermediate-term high-yield

We're not recommending that you venture into the riskiest realm of junk bonds. But good quality high-yield offers better rates than investment-grade bonds -- around six percentage points over Treasuries for the former vs. two for the latter. The advantage of all corporate debt, and especially high-yield, over Treasuries is that credit spreads typically shrink in an economic recovery as sales rise and balance sheets strengthen. The decline in spreads will help offset the inevitable increase in benchmark Treasury rates. As a result, high-yield investors should see not only far higher annual payments but also smaller drops in price.

An excellent choice: BlackRock's iShares iBoxx High Yield Corporate Bond Fund (HYG). This ETF offers a yield of 8%, and the average maturity is a relatively safe five years.

Emerging market bonds

The sovereign debt of nations such as Brazil and Indonesia offers a huge upside. "Emerging-market debt represents a marvelous opportunity," says Rob Arnott, founder of Research Affiliates. In general, emerging-market countries have much less debt relative to their size than those in the developed world. Their "real," or inflation-adjusted, yields are far higher than those in the U.S. And their bonds face less risk that rates will rise, since most of these countries are already recovering strongly. Emerging-market bond funds also offer an opportunity to profit from a declining dollar, since their holdings are in local currencies.

A good pick is Pimco's Emerging Local Bond Fund (PELAX). Two-thirds of the mutual fund's holdings are in three countries: Brazil, Mexico, and Indonesia. The yield is 4.2%, and while that might seem low, the average maturity is less than seven years. So just compare that number to the less than 2% yield on seven-year Treasuries.

Floating rate bank loans

This increasingly popular category of fixed income is an excellent vehicle for avoiding interest rate risk. These funds buy loans that banks make to corporations. Those loans, instead of offering a fixed rate, pay interest that typically floats at a fixed margin over a benchmark rate. So when rates reset higher, these securities pay you more. The only risk is credit -- the chance that the issuers will default or suffer a downgrade. In the past, many of the bank loan securities were issued to fund leverage buyouts and performed terribly in the credit crisis of 2008. Today's loans are generally safer: They're fully secured by such assets as plants and capital equipment. BlackRock's Floating Rate Income Trust (BGT) offers a yield of 5.6%. The duration, or risk the price will fall if rates rise, is extremely low.

Go-anywhere funds

Another fixed-income offering that's growing rapidly: funds that allow top managers to search for the best opportunities anywhere in the world, in any asset class, while shunning risk and keeping duration relatively low. Two excellent picks were launched by Pimco and BlackRock in 2008. The BlackRock offering is called the Strategic Income Opportunities Fund (BASIX), and the Pimco product is colorfully named the Unconstrained Bond Fund (PUBAX). Right now Strategic Income pays 4.1%, easily outyielding 10-year Treasuries. The Unconstrained Fund currently has a 2.5% yield, or about three times that of a three-year Treasury note, on a portfolio of very short-maturity bonds. Both funds are great examples of how, in today's fixed-income environment, it pays to rethink the tried-and-true strategy.

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About This Author
Shawn Tully
Shawn Tully
Senior EDITOR-AT-LARGE, Fortune

Shawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.

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