by Cynthia Harrington
After three years of back-to-back gains, bonds look a little tired. Advisors are lightening up, shortening up and, more than occasionally, giving up. With yields this low and prices this high, little else can happen but that the trends will reverse.
"I’m seeing the kind of capitulation that had investors abandon reason and flood into dot-coms at the top," said Mitchell Freedman, CPA, PFS, of Mitchell Freedman Accountancy Corp., in Sherman Oaks, Calif. "People who missed the last two-year run with bonds now are cashing out of equities and buying bonds.
He added, "Once again they’re taken in by the financial press telling them what mutual funds did well the previous quarter."
The numbers prove it
According to mutual fund trade organization the Investment Company Institute, $22 billion of the year’s $109 billion increase in bond fund assets came in September and October alone. The latest purchases are atop a $71 billion inflow in 2001. Bond funds have become the magnet, with funds flowing out of stocks and money market funds chasing yesterday’s hot performers.
"I’m not a market timer, but I want to examine markets to
avoid major mistakes," explained Freedman. "I believe all clients should have significant fixed-income assets, but not in the long end of the yield curve."
"We’re close to 30- and 40-year lows in interest rates and we don’t want to be in long bonds," said Dennis Gurtz, CFA, CPA, CFP, PFS, of American Express Financial Advisors, in Bethesda, Md. "We’ve been shifting from long-to-intermediate term bonds over the last year. Shorter bonds will go down if interest rates rise but not as much. We’re not even giving up too much current yield to be in shorter bonds."
With 30-year yields at 4.92 percent, the 4.05 percent on 10-year bonds looks attractive. "The purpose of fixed-income assets now is not so much to contribute to huge returns but to reduce overall volatility," said Freedman.
Advisors following strict re-balancing strategies will be cashing out of both long and intermediate bonds. Assets in both class subsets increased at near double-digit annual rates over the last three years. The increases form the only bright spot in most portfolios and will have to be reduced to maintain broad allocation goals.
Those following a strict optimization process would see the gains in bonds going into the category with big losses - domestic large cap growth, down by over 20 percent in the last three years. "In general we’re allocating away from aggressive, volatile assets like emerging markets or small cap stocks," said Gurtz.
Gurtz just re-balanced the portfolio of a foundation. For the regular year-end adjustment, he sold long bonds to raise cash in order to fund the annual grants. "What they didn’t give away we recommitted to U.S. equities, raising the overall allocation," he said.
Despite the fact that many of the investors still seeking bonds are flooding into his mutual fund, Bill Gross, chief investment officer at PIMCO, predicted a tough road for bonds in the near future. With over $64 billion in assets, PIMCO’s Total Return Fund tops not just the size chart for bond funds but is now the largest mutual fund in the country.
From his perch atop the mutual fund rankings, Gross’ opinions resonate. In his recent letter to shareholders, he sounded a note of caution on the twin devils of bond investors - rising interest rates and rising inflation rates. "If the cost of money in the U.S. can’t go down, then it must eventually go up. The questions to ask are 'When?’ and ÔHow much?’"
The third challenge to bond investors is the credit quality of issuers. While high-quality bonds brightened up returns, lower-credit-quality markets proved to be active minefields. With current yields still at 8 percent, the total return of the Lehman High Yield Index over the last year is down by 3.16 percent and hasn’t seen daylight for three years.
The reasons are the high number of defaults and the billions lost with no hope of recovery in dot-coms and companies that fraudulently reported their financial conditions. Through December 2002, defaults totaled $136 billion. Compare that to just $2.3 billion in 1994, less than a decade ago. Paltry or negative corporate profits depressed prices of lower quality bonds across the board.
However, the brightening economy that portends higher inflation and interest rates could be good news for investors in lower-credit-quality bonds.
Convincing clients and prospective clients of the dangerous currents of bond investing is top on the list for Freedman. A recent meeting with two prospective clients illustrated the problem investors are creating for themselves. The couple is successful, and they have accumulated wealth as an executive and a real estate agent. After a 50 percent drop in their previously tech-rich portfolio, they had sold out of equities and put everything into bonds.
"He mostly came to see me on the strength of a recommendation of another client to get reassurance for his decision. Within the last month he’d put all his funds into a long-term bond fund," said Freedman. "These are smart people, sophisticated. They understand risk in other areas and they understand bubbles in the real estate market. But they had made exactly the wrong decision. They’re neophytes when it comes to the stock and bond markets."
"The problem," he added, "is that they don’t understand what Ôtotal return’ in a bond fund means. The market appreciation portion of the return is going to be wiped out when interest rates rise again," he said. "For long bonds, the increase is going to be bad enough that the current yield won’t be enough to balance out negative total returns on long bonds."
If interest rates look like those of 30 years ago, today’s price chart forms an opposite pattern of those 20 years ago. In 1982, prices of high-quality bonds dropped to 50 cents on the dollar as short term rates rose to 18 percent.
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