While rising interest rates have hurt bond funds in general, there are several subsectors of that market that are doing OK.
The media has portrayed the bond market as a bloodbath where investors are losing their shirts.
A rising rate environment is obviously not ideal for a bond portfolio, but the downside from here is likely very low compared to stocks.
We highlight the funds that have positive returns YTD in the closed-end taxable bond fund space.
The media has been all over the fact that bond funds are getting crushed by increasing interest rates. Sure, many bond funds are down single digits from the higher rates. But let's put it into perspective.
The 10-year government bond yield has moved up from 2.41% on January 1 to 3.10% recently. If the duration of the security is 8 years, your $100 invested into the security is worth approximately $95.
10-Year Treasury Rate data by YCharts
If the yield continues higher to 4%, which some well-known bankers are thinking, that $100 would be worth less than $88. Most people believe we have moved into a rising rate environment and that a bond bear market is at hand.
For example, JPMorgan (NYSE:JPM) believes a 10-year bond bear market has started. If that is the case, bonds are no longer the safe haven that they have been over the past 35 years. We recently wrote about the death of the 60/40 portfolio given that 40% in fixed income is unlikely to provide the same level of contribution that it has in the past.
Should interest rates continue to rise for the next two years as they have so far in 2018, the declines in some popular "safe" investments could be compounded. For example, look at the pain inflected by higher rates on the iShares 20+ year Treasury Bond ETF (TLT):
TLT Total Return Price data by YCharts
We have noted several times that most retail, do-it-yourself investors tend to focus significantly more on their stock selections and then simply buy an intermediate core bond fund for their fixed income. This is primarily because most people aren't as familiar with bonds as they are with stocks, even though the bond market is several times the size of the equity market.
Most intermediate bond funds are down YTD and their 3-year numbers are well below historical averages. Are we likely to continue seeing this in the future as rates rise further? Most likely. A 60/40 portfolio historically earned nearly 8% with a 6% return from the bond sleeve and a nearly 10% total return from the equities. Going forward, the 40% invested in bonds is likely to be near dead money, earning around 2% per year.
Below is a list of Morningstar returns by category. The YTD figures for the fixed income category are not good with just a few subsectors in positive territory:
More importantly, look at the 3- and 5-year numbers. Given the mostly negative YTD returns, the already low returns over the last few years are being weighed down further. The best segments, preferred stock (+4.85%), EM bonds (+3.98%), and High yield bonds (+3.83%), are unlikely to provide the same returns going forward.
The top performer, bank loans, otherwise known as floating rate bonds, is not a surprise as the best category. These are positively correlated to higher rates and as repricings among floating rate bonds subside (as they have starting this year) the category has performed much better.
We focus primarily on the closed-end fund space for our bond allocation and current income needs. This is due to the superior structure of the closed-end fund vehicle not having the 'cash flow problem' that an open end fund contains. For one, look at annual turnover rates for open-end funds and compare them to closed-end funds. Open-end bonds funds are typically between 400% and 1,000%, while closed end funds are often below 100% and average closer to 25%.
New cash into an open end fund has to be invested at the current low rates diluting old investors who added capital when rates were higher. In some cases, substantially higher. The closed-end fund space has generally outperformed the open counterparts as they have significantly more tools in their tool chest. Below we rank the funds based on YTD return on NAV.
Most of the funds are in the senior loan space, which are floating rate securities and positively correlated to interest rates. Most of the rest are high yield, which tend to be less sensitive to interest rate movements because they have higher coupons reducing duration, and tend to have less time to maturity.
Multisector is where most of the PIMCO funds fall. These are as close to publicly-traded hedge funds as a retail investor can find. We have detailed these funds significantly over the past few years calling PDI (and now PCI) as the "Greatest Bond Funds Ever."
Many of the top funds on the list are in our Core Portfolio. Of course, we do not want to overcommit to one subsector of bond asset class in case we are wrong. Senior loans and high yield make up more than half of our Core Income Portfolio today.
The top funds remain the PIMCO non-agency plays, PIMCO Dynamic Income and PIMCO Dynamic Income and Mortgage. The two funds are very similar but one trades at a discount to NAV while the other at a premium. Still, the distribution yield of the two funds are fairly similar which tells you the market is just arbitraging them to be near equal. Below is the performance of PDI through June 11th.
PDI is now up over 5% YTD, which, when you think about it, is truly heroic for a bond fund. This is a fund that is hedged to interest rates, both on the short end of the curve and on the long end. Interest rates swaps on the short end are meant to hedge higher financing costs for the leverage. Swaps on the long end are meant to protect the NAV of the fund.
Re-running the screen without convertibles or senior loan funds, most of the top funds are multi-sector. PDI and PCI are near the top of the list. The returns on the two "sister" funds are similar showing the comparability of the funds.
The notion that you are forced to move into stocks for dividends because you have to avoid bonds is hogwash. Using fundamental analysis, you can decipher which funds are more interest-rate sensitive and which are positively correlated to higher rates. A closed-end fund has significantly more flexibility to hedge and construct the portfolio to mitigate risks.
While this equity market likely has a bit more room to run, eventually another recession/bear market will arrive. Until then, not experiencing FOMO and over-allocating to stocks while positioning the bond sleeve opportunistically can result in superior returns.
We have launched a complimentary portfolio for our members to follow our lead on opportunistic trades, mostly in the closed-end fund space. This would be more short-term-oriented to take advantage of two things:
- Clear mean reversion trades where we see at least 200 bps of discount closure plus like the underlying exposure.
- Opportunistic special situations including liquidations, tender offers, and term discounts.
- Momentum subsector exposures that we think are likely to be the places to be.
Given that this report was published to members about 3 weeks ago, we will release one of the five initial funds in our opportunistic bucket. That fund is NexPoint Strategic Opp (NHF), a special situation opportunity following a non-transferable rights offering. We calculated that the NAV would end up between $24.70 and $24.80, giving the fund an 11% discount to NAV.
The NAV did come out to be $24.81 but the price had risen about 28 cents over the subsequent 5 trading days until they released the new diluted NAV. The discount had closed to just over 10%. Today, the price has moved up another 27 cents plus another 20 cents for the distribution (ex-date was 6/8) for a significant move in the last approximately two weeks.
We will follow up with the other four trades over the next month as well subsequent trades severely delayed. Make sure you follow us in order to get those trades and updates right to your email. Or consider joining our community of income investors in what we believe is the last bastion of inefficiencies in the market.
Our approach is to build a total portfolio of income producing securities across the capital structure (senior secured bonds down to common stocks and everything in between). We have two easy-to-follow portfolios on spreadsheets that update in real-time. For further information, check out our blog posts each month on our Core Portfolio and our main public site articles that give a bit more detail.
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Disclosure: I am/we are long NHF, PCI, PDI.