How to Navigate the Shifting Bond Market

The stock market gets most of the headlines, but bonds have had more fireworks the last few months. Bond and other income investors have been sitting pretty – beating the stock market for an extended period.  Unfortunately, they now might be in a bubble similar to that of technology stocks in 1999 and early 2000.

Two factors caused most of the bond outperformance and the sharp decline in treasury interest rates during the middle of 2002. Investors fled everything else for the safest investments – treasury bonds. Also, mortgage rates fell to multi-decade lows, and homeowners refinanced mortgages in record numbers. The refinancing caused mortgage guarantors Fannie Mae and Freddie Mac to buy treasuries to balance their portfolios.

Two economic futures are most likely. One scenario is that we have another recession and a period of economic stagnation. The other scenario is a period of slow, steady economic growth. In the first scenario, treasury bonds would continue to appreciate as interest rates fell and investors sold other assets. In the second scenario, interest rates would rise a bit and investors would sell treasuries as other investments become more attractive.

I think the second scenario is more likely, posing a double threat to bond investors. Income from treasuries and mortgages (which we buy through GNMA funds) are low. Yields for the next 12 months on GNMA funds are likely to be 3.5% to 4% after fund expenses. Treasury yields are even lower than GNMA yields.  These low yields could be coupled with capital losses if investors start selling bonds. A warning sign of this is the recent flood of investor money into bond funds; this looks similar to the rush into technology stocks just before their peaks.

Here is how I recommend income investors plan for the combination of low income from current investments and possible capital losses.

• Treasury-only bond funds are not in my recommended portfolios right now. If you own any, consider switching out of them now or establishing sell signals roughly 5% below current net asset value. 
• Hold onto your corporate bond and high-yield bond funds. The gap between their yields and those on treasuries never has been wider. Widespread investor fear created deep discounts in these bonds because of worries that many more corporations default on their bonds and file for bankruptcy. I believe these fears are overblown. My recommended bond fund managers are conservative and thoroughly examine a company’s financial statements before purchasing the bonds. I believe the economy is growing slowly and will grow a bit more strongly in the future, so these bonds look like bargains to me. 
• Don’t worry about the safety of GNMAs. There have been reports about the risks being taken by Fannie Mae and Freddie Mac, which buy and guarantee the repayment of many home mortgages. These firms are not related to GNMA. Importantly, GNMA has a direct guarantee from the federal government, while Fannie Mae and Freddie Mac have only implied guarantees. 
• I’m adding a sell signal for the GNMA in all four Managed Portfolios. If treasury rates rise, the value of these bonds will decline. We don’t want to give up too much of our capital gains. Sell Vanguard GNMA if the price falls below $10.23. Put the sale proceeds in a money market fund until receiving the next issue. For those who won’t want to wait, rising treasury and mortgage rates most likely will signal an increase in economic growth. In that case, my recommendations for reinvesting the probably would be Dodge & Cox Income and Columbia High Yield. 
• International bonds also are getting a sell signal. Sell American Century International Bond if its net asset value falls below $11.35. 
• Make plans to compensate for lower yields from safe income investments. Money market yields are so low that after expenses many funds yield less than 1%. Even low-expense funds yield less than 2%. After taxes, there hardly is any yield. The yield on even 10-year treasury bonds is around 3%. Only more risky assets, such as corporate bonds earn the yields investors were used to just a year ago.

  Your cash might be better deployed than in money market funds and CDs. A short-term bond fund gets you a yield of 3% or so with a low risk of principal loss if interest rates rise. If you have any debt, consider taking cash out of low-yielding investments and using it to pay off the debt. Don’t use cash that is kept for emergencies and unplanned major expenses. Also, if you don’t have enough “guaranteed income” to get a home equity loan approved, you might not want to use cash to pay off a mortgage. Otherwise, using low-yielding cash to pay off higher-yielding debt can greatly increase your net worth and cash flow.