As if the last 18 months have not been challenging enough for stock investors, even the world of bond investing has become more complicated. Just as there are many things that affect stock prices there are certainly forces pushing the bond market around. Interest rates, currency values and fear are just a few of those forces affecting bond prices. So what is an investor to do these days?
Navigating the bond world
Let’s take a look at the forces challenging bond investors.
- US interest rates – with record low interest rates its hard finding safe, respectable yields. The other problem with extremely low rates is that they will soon be rising which pushes down the prices of bonds. So, what types of bonds prosper in an environment of low rates with the prospect of rates rising soon. The answer is Floating Rate Funds. A floating rate fund is also known as a Senior Bank Loan fund. These types of funds invest in floating rate loans made directly from banks to companies that are considered less than credit worthy. These types of funds tend to do well in a rising interest rate environment (versus traditional bonds which tend to fall in a rising rate environment) due to the interest rates adjusting on the loans every 30-90 days.. The loans are considered senior loans in the capital structure of the borrower which means that these loans are repaid first in the event of a bankruptcy by the borrower. The unfortunate thing about these types of funds is there are no ETFs in this space so you will have to use a mutual fund. I know I am an ETF cheerleader but you cannot deny that these fund do well in a rising rate environment. Check out Eaton Vance’s Floating Rate Fund (EABLX) or Fidelity’s Floating Rate Fund (FFRHX).
- Currency values – while currency values do affect US bonds more particularly if the US dollar is going up foreign bonds weaken and if the US dollar is falling foreign bonds get a boost. The conundrum today is the dollar has risen versus foreign currencies thanks to the weak Euro and the questionable fundamentals in the US stock markets. Many believe the strength in the dollar is short-term since the US is racking up significant deficits which will weaken the dollar long-term. Since we follow trends around here avoiding foreign bonds currently has been wise. That may not last too long. Once the dollar begins its retreat foreign bonds will be back en vogue. Fortunately, there are a few ETFs in the foreign bond space such as the SPDR Barclays Capital International Treasury (ticker BWX), and the SPDR Short-Term International Treasury (ticker BWZ). The iShares Emerging Market ETF (ticker EMB) purchases US Dollar denominated emerging market bonds and therefore is not affected so much by the fluctuations of the US dollar.
- Fear – as investors fear weakness in stocks a flight to the safety of US Treasuries and high quality corporate bonds takes place. The danger here is investments in US Treasuries has been significant which has pushed prices up and yields down. The run into treasuries has been a result of the economic crisis and continued concern of a return to a falling stock market. This has kept prices relatively high and yield low. When the tide truly turns and investors are again willing to take stock market risk there will likely be a considerable drop in the value of US treasuries.
Let’s revisit interest rates. There is a rule of thumb that might prove useful in managing your bond portfolio. The rule of thumb has to do with the nature of interest rates. Rates can either go up, down or stay flat for a time. So, where should you look in each environment? In a rising rate environment you want to look at floating rate funds and ultra short-term corporate bonds. In a falling rate environment you want to look at intermediate to long-term corporate or government bonds. In a stable rate environment GNMA bond funds tend to do well.
The biggest mistake many investors make with bond investing is thinking that just having a bond fund or two is enough. Bond investing, like stock investing should be dynamic as there are many forces pushing an pulling bond prices and yields which means t here is not really an all seasons bond fund.
Disclosure Statement: ETFGPS is a blog that Navigates The World of ETFs. Sustainable Investment Strategies LLC is a Registered Investment Adviser in the State of Maryland, and does hold positions in ticker EABLX at the time of writing. Investors who are interested in money management services may visit the Sustainable Investment Strategies LLC web site
