So the debt crisis passed when Congress grudgingly agreed to raise the federal debt ceiling and promised to cut trillions of dollars in future government spending. While hardly a cause for celebration, avoiding the first-ever default by the U.S. government counts at least as mildly positive news, as did the July jobs report on August 4, but that didn’t stop investors from sending the stock market to new lows for the year in the days following the agreement. This week, following the downgrade of the U.S. on Friday, more volatility is possible in the markets.
Why the negativity? As the debt ceiling agreement was taking shape, newly arriving economic data signaled increasingly clearly that not only is the U.S. economy growing at a slower rate than would be expected during a period of economic recovery, but it is decelerating from even the 1.3% rate witnessed during the second quarter of 2011. Fixed income markets apparently got the news early: while bond yields for heavily indebted European governments like Greece, Spain, and Italy have spiked higher on the threat of potential default there, the yield on the benchmark U.S. 10-year Treasury note fell below 2.6%, its lowest since November 2010, as the deadline for lifting the debt ceiling approached, and is now within 40 basis points of the low of 2.20% set in the darkest hours of the financial market meltdown in January 2009.
The lack of growth in the second half of 2011 has major implications for investors today, as a cooling economy often drags equity markets down with it. Dividends, of course, will be paid, but with the Standard & Poor’s 500 index yielding a lean 2.0% currently—and the threat of price depreciation rising—only a committed optimist would bet that stocks are the place to be in the waning months of 2011.
Among other asset classes, commodities have performed well in recent months, but they are volatile and—like equities—tend to follow patterns in global economic growth. For those seeking acceptable returns with some measure of safety, fixed income assets are looking increasingly attractive.
In order to find funds that have the potential to deliver respectable returns in the coming months, we searched the world of taxable fixed income funds for those that have delivered consistently strong results over the past three- and five-year periods and have the highest five-star rank from S&P. With the U.S. dollar expected to come under further pressure if the economy slows, we took special note of funds that had at least a portion of their assets invested in foreign currency instruments. Three funds stood out for their above-average historical performance, high current yield and currency diversification.
Three Taxable Bond Funds to Consider
For those willing to forgo some yield in favor of a globally diversified portfolio of government-backed bonds, the Templeton Global Bond Fund (TPINX) is one choice. Its current yield of 3.06% is well above the yield on the 10-year U.S. Treasury note despite the fact that the portfolio has an average duration of just 1.74 years—important if interest rates unexpectedly rise. With $59 billion in assets, it one of the largest bond funds in the U.S., and its portfolio manager’s tenure of 10 years is a welcome sign of stability. The fund has delivered an average annual return of 11.94% over the past five years, second best among S&P’s five-star-ranked taxable fixed income funds, and 13.25% over the past three years, a top 10 showing for that group. Also, less than half its assets are U.S.-dollar denominated.
For those willing to take on more risk for more yield, the TCW Emerging Markets Income fund (TGEIX) offers an enticing 7.51% current yield. The fund’s performance has been outstanding in recent years; over the past five-year period, it delivered an average annual return of 12.98%, best of all U.S. taxable fixed income mutual funds open that long, and its 17.63% average annual return over the past three years is the best for that period as well. Such strong returns and high yield hasn’t come without taking on risk, however; the fund invests in debt that is either unrated or rated BB and lower. On a country basis, Brazil was its largest holding as of June 30, followed by China, Russia, Argentina, Mexico and Turkey. About 25% of its holdings are in non-U.S.-dollar assets and its average duration is high at 10.76 years.
The Payden Emerging Markets Income Fund (PYEMX) could be said to represent a happy medium. Its current yield is 5.84%, and it has about 45% of its assets in investment-grade debt. More than three quarters of its holdings are government issued, compared with 27% for the TCW fund. The fund’s performance has been strong over time: its 9.42% average annual return over the past five years is fifth best among five-star taxable fixed income funds, and its three-year return of 12.25% is well above average for that group. Russia, Brazil, Indonesia, Venezuela and Mexico are its largest country exposures. Most of the fund’s assets are dollar denominated, and its average duration is 7 years.
S&P Senior Editorial Manager Vaughan Scully can be reached at Vaughan_scully@standardandpoors.com. Send him your ideas for ETF and mutual fund stories.