Bond markets have been on a tear. But given conditions in the economy and recent measures taken by the Federal Reserve, experts say, it may be time to take a fresh look at existing fixed-income holdings and consider alternative holdings.
“The ‘lost decade’ for equity, two grueling bear markets and an aging demographic have investors running for cover in fixed income,” said Chris Dillon, a portfolio specialist with T. Rowe Price, in a recent presentation he made in Phoenix during Commonwealth Financial Network’s national conference.
While many investors have focused on five-year Treasuries, “Diversification into higher yielding ‘spread’ sectors warrants consideration in the current environment,” Dillon explained.
Select municipal and corporate bonds have an “interesting” story to tell these days. Some BB-rated high yields, he points out, have a yield spread of 480 basis points (or 4.8 percent) over Treasuries. And emerging-market corporate and local bonds are also worth consideration. About 70 percent is investment grade, and that figure should rise to 80 percent as Turkey’s debt is upgraded. “Emerging-market debt is becoming attractive to pension funds,” Dillon said.
Taking a historical perspective, “We are not necessarily in a bond bubble,” Dillon said. But there are some issues that warrant further consideration in the fixed-income arena, he adds, especially with respect to U.S. Treasuries, which “quite possibly” are in a bubble. “The yield curve is flattening, and things can unwind quickly,” Dillon explained.
Traditional high-yield bonds generally perform well when rates rise, with some exceptions. And the same is true for investment-grade municipals, Dillon says. “When it comes to U.S. high yield and emerging-market debt, there is still some value left,” he noted.
In municipals, “Risk has been re-priced into the market,” Dillon explained, which has his team targeting bonds rated AA or below. “Without a double-dip recession or deflation, there is little value in Treasuries or AAAs.”
Other fixed-income investments of interest to T. Rowe are select floating-rate notes and bank loans, as well as California Economic Recovery Bonds.
Stephen Rudolph of HW Financial Advisors, an RIA affiliated with Commonwealth Financial in Cleveland, however, believes it’s important that investors understand that bonds may be safe in some respects but won’t produce adequate returns for the long term. For instance, the many higher-quality bond funds have yields of only around 2 percent.
“Given that we do not see much return left in bonds and that they are not risk free, we are aggressively selling corporate bonds,” he said during the Phoenix event.
There’s a lot of emotion involved in the current wave of bond buying, which is seeing inflows of $5 billion to $10 billion a week, he points out. “Bonds have done well the last 5, 10, 20 years, but that’s chasing past performance and the sign of a massive bubble,” Rudolph explained.
When interest rates start moving up, it is possible that investors in bond funds could actually lose money even after accounting for the interest on the bonds, he says. “If interest rates spike up dramatically, these losses could surprise a lot of people that think they are being conservative and are trying to protect themselves from losing money. This is because bond prices tend to move in the opposite direction of interest rate moves,” said Rudolph.
Thus, the advisor is looking at floating-rate bond funds, which should perform well with interest rates at 4 to 6 percent. And he’s discussing high-quality dividend-paying stocks with his clients.
“I have never seen a time when you can get a higher yield on high-quality dividend paying stocks than what their bonds pay,” Rudolph explained. “Additionally, unlike bonds, most of these companies increase their dividends every year, providing some inflation protection. Many of these stocks look attractive vs. their bonds, and they also are very global in scope.”
Plus, he’s focusing on hedge funds and alternative-strategy funds offered in a mutual-fund format — those funds that have a low correlation to stocks and bonds, such as long/short funds, merger arbitrage, market neutral funds, commodities, etc.