Shake Up In the Bond Market

The fixed income world has changed, making it time to adjust our Income Portfolios. Government budget surpluses, shrinking supplies of treasury bonds, low inflation, and other factors changed the bond market over the last couple of years and will affect it for years. Those who don’t throw out the old rules and adapt to this new world will leave a lot of money on the table.

Until recently, an easy way to get the highest yield and total return from bonds was to buy intermediate treasury bonds or a ladder of treasury bonds that mature in different years. Either method was a great strategy. But with inflation in a long-term downtrend, yields on treasury bonds are low. Yields are too low for many investors to get adequate income from treasury bonds. Even worse, federal budget surpluses are taking treasury bonds out of circulation. The Treasury recently announced that it would no longer issue one-year bonds. Investors who crave maximum safety are bidding for the remaining treasury bonds, driving yields lower and making treasuries expensive compared to other types of bonds.

The long-term decline in inflation makes it difficult for bond fund managers to beat the bond indexes. Fund managers used to add value by buying longer-term bonds when interest rates were high and capturing capital gains as rates fell. There are fewer opportunities to do that since interest rates are stuck in a narrow range. Precious few bond fund managers are able to earn a higher yield or total return than a bond index fund.

To fit the new fixed income market, I’m overhauling our recommended Income Portfolios. They will be simpler, have a higher yield, and earn a higher total return. They also will be safe. In today’s bond market, most investors have to settle for a yield between 4% and 5%. We’ll start off with a yield of over 6% and have a good shot at improving on that from time to time.

My Income Portfolios are for those who want a high, safe yield, and who are investing for five years or less. This overhaul also is important for Sector and Balanced investors. I often urge investors who are in or near retirement to have three to five years’ expenses in bonds, in addition to following my recommended Sector or Balanced Portfolios with the rest of their assets. That three to five years of expenses can be invested in either a bond index fund or in the new Income Portfolio.

I’m dropping balanced funds and real estate investment trusts from the Income Portfolios. Because the portfolio is for investments of five years or less, the capital gains are not needed to overcome the effects of the low inflation I see in the future. For income investors in today’s low-yield world, the higher, safe yield is more important.

For most income investors the Core Income Portfolio will be PIMCO Total Return D. The fund is run by Bill Gross, the premier bond manager in the U.S. I have not recommended his funds in the past because they came with high loads and expenses. But a couple of years ago PIMCO finally came out with a no-load and lower-expense D shares for many of its funds. Buy only the D shares of PIMCO Total Return. The fund has higher expenses than a bond index fund, but PIMCO consistently has delivered higher-than-index-fund returns after subtracting expenses. The fund yields just over 6%.

If you don’t want to buy PIMCO, stick with an index fund. It will beat almost all other managed bond funds and also a basket of treasury bonds. Vanguard Total Bond Index is the best with the lowest fees. Or you can use Schwab Total Bond Market Index.

Do you want a little higher yield from the Core Income Portfolio or do who want to invest for yield for longer than five years?

In those cases, a good move is to add some preferred stock to the Core Portfolio. There are no good open-end mutual funds that emphasize preferreds. If you don’t want to pick and choose individual preferred shares, I recommend a closed-end fund, Preferred Income Fund (NYSE; Ticker: PFD). Closed-end funds are sold over the stock exchanges just like regular company stock. Share prices are determined by supply and demand, so the prices usually are either higher or lower than the underlying net asset value of the fund (a premium or discount).

Preferred stock is somewhere between common stock and a bond. Preferreds offer a high yield, usually 7% or more today. The value of preferred stock tends to move up and down with interest rate changes and can be as volatile as long-term treasury bonds. In periods of rising interest rates, PFD could lose 10% or a little more of its net asset value. Because of this volatility, I’m not recommending it for all Income Investors. It is only for those who want the higher yield, don’t mind the possible volatility, and probably plan to hold for longer than five years. Keep preferreds to 30% to 40% of your Core Income Portfolio.

PFD invests primarily in banking and utility preferreds. Its top 10 holdings make up almost 40% of the portfolio and right now primarily are banks, such as Citigroup, Bank One, Bear Stearns, Wells Fargo, and HSBC USA. The funds has paid a monthly dividend of $.082 per share since January 2000. At the recent share price of $13.65, that comes to an annual yield of 7.2%. The fund uses hedging strategies to keep its yield from declining much as interest rates decline.

PFD normally trades at a discount to its net asset value. But in the last six months the price has held close to net asset value. Sometimes it sells at a slight premium. You should be careful not to pay a premium and might want to wait for it to return to selling at a discount. For details about the fund, check its web site www.preferredincome.com.

In the Managed Income Portfolio, we’ll be seeking out low-risk opportunities for high yields with some capital gain potential. Over time, we’ll invest in high yield corporate bonds, emerging market bonds, international bonds, mortgages, corporate bonds, and other vehicles.

Right now, I see only one opportunity for the Managed Income Portfolio.
Mortgages, or GNMAs, look good. They have a higher yield than most other bonds. They tend to be as safe as treasury bonds with a better return. The main risk is that the mortgages will be paid off as interest rates fall. I think that interest rates are low enough that this won’t be the problem it was in past cycles. I like Vanguard GNMA for this investment.

We’ll look at high yield bonds later in the year. They were a bargain last December, then had their best month ever in January and did well in February before retreating. They are not a big enough bargain for me to put into the portfolio right now, and concerns about the economy will keep the lid on prices for a while. I’m also taking a look at emerging market bonds. But there are problems in Argentina and Turkey that haven’t been resolved.

What about short-term cash investments, those for money you might need n a year or two? Money market funds and even treasury bills usually yield more than bank certificates of deposit. But even better yields are available from short-term bond funds. If your time horizon is one to two years, consider Vanguard Short-Term Bond Index. You’ll get a yield of about 6% now, and the principal value should fluctuate by only a few pennies per share over several months. In 1994, a very bad year for bonds, the Vanguard short-term bond funds in existence at the time lost less than 1% for the year. It’s not as safe as a money market fund, but if you think rates aren’t likely to rise you’ll get a higher yield with low risk.