With yields across the credit and duration spectrum near all-time lows, fixed- income investors are hard-pressed to find value in the bond market. But that doesn't mean value is absent and opportunities are nonexistent.
“The challenges in the market are no secret,” Michael Mata, manager of the ING Global Bond Fund, said Tuesday during an InvestmentNews
webcast, “Finding Risks and Opportunities in Fixed Income.”
“The 10-year Treasury bond is around 2% and has been since 2011,” he said. “It's worse now because spreads have compressed and it's hard to find value in investment-grade and high-yield bonds.”
Managers such as Mr. Mata are walking a fine line between the risk that economic growth is too strong — causing a rapid rise in interest rates, or too weak — resulting in a widening of credit spreads. Either scenario could put pressure on the prices of a wide range of bonds, potentially wiping out already slim yields.
The three participants in the webcast emphasized the need for flexibility in fixed-income allocations, given the precarious combination of low interest rates and uncertain economic conditions.
“Bonds are the safe assets for clients. Investors want income from them, but the primary role of bonds is to protect principal,” said J. Brent Burns, president of Asset Dedication LLC, a company that manages separate accounts for independent financial advisers. “For a lot of people in retirement, their principal isn't as protected as they think.”
The risk is particularly acute for bond fund investors, given the lack of a maturity date on the investment. As interest rates rise, the prices of bond holdings in funds will drop — as will the net asset value of an investor's shares in the fund.
“If you're an individual bond holder, you can hold your bond to maturity and you know what your worst-case scenario is,” Mr. Burns said. “Bond funds with no defined maturity date can't protect principal as well.”
One solution being offered to financial advisers is defined-maturity exchange- traded bond funds. Guggenheim Partners LLC now offers eight investment-grade and six high-yield bond funds that mature at year-end for years ranging from 2013 to 2020.
The BulletShares ETFs give investors a diversified portfolio of bonds with the same maturity date. Investors can construct a ladder of the funds to give them a range of maturity exposures. “No one knows when rates will increase and by how much — and yet investors are starved for yield,” said William Belden, head of product development for Guggenheim Investments. “Defined-maturity ETFs address the risks from the interest rate perspective.”
Mr. Belden focuses on providing advisers with solutions for different interest-rate scenarios. An increasingly popular scheme is the use of floating-rate bonds, which are typically pegged to a market rate like Libor. The yield is less than analogous fixed-rate securities, but it increases as the rate benchmark rises. There is a risk that a rapid rise in rates could slam issuers with higher interest costs and potentially increase their credit risk profile. But the floating yield protects investors.
“It's a nice solution to mitigate rising rate risk,” Mr. Belden said.
For the time being, all three participants expect that interest rates are more likely to rise slowly than rapidly. Mr. Mata expects the Federal Reserve to continue to keep rates low on both the short and long ends of the spectrum.
“We won't see a repeat of 1994, but we expect moderately higher rates this year,” he said, referring to the sharp increase in rates during that period.
Mr. Burns too thinks the Fed will continue to keep rates down, given anemic economic growth and the enormous federal debt load. “The Fed doesn't control spreads, but it has a lot of leverage over rates,” Mr. Burns said. “Mr. Bernanke has said he wants to keep rates low out to 2015.”
Nevertheless, Mr. Mata said the biggest risk is that the rise in rates proves to be rapid. “A 100-basis-point rise in yields would be positive for fixed-income investors, but if it's a quick rise in rates, it will have a negative effect on retail investors,” he said.
