Navigating today's bond market is a treacherous business. Bonds,
in my view, are in a bubble. Yields are too low and when they rise,
as they surely will, prices of most bonds will fall. No one can
tell you when the next bond bear market will begin, but it will pay
to be prepared. This article offers my best picks for avoiding
losses, and making small profits, when bond yields begin a
Contrary to all expectations, the bond market has stormed ahead
so far this year--that is, yields have fallen and prices, which
move in the opposite direction of yields, have climbed. The best
performers have been high-quality, long-term bonds. Case in point:
So far in 2014, Vanguard Long-Term Treasury (symbol
) has returned a sizzling 10.1%. (All returns in this article are
through June 10.)
The Vanguard fund yields a meager 3.1%. That's just about what
inflation has averaged annually over the long term. If consumer
prices rise by that much over the next 20 or 30 years, you'll
probably earn no more than the fund's yield over that period,
allowing you to break even in real terms.
That's the optimistic case. What's the downside? Consumer prices
could rise at a faster pace, which would almost certainly push up
bond yields. Indeed, because yields are so low today, they're
likely to rise without any appreciable increase in the inflation
rate. Should yields on bonds of similar maturities rise by one
percentage point, this fund's price will plunge a jaw-dropping
15.3%. That's, of course, without even considering the impact of
inflation. So much for the safety of Treasury bonds.
Unfortunately, the odds of yields staying flat or falling are
negligible. Thanks to the Federal Reserve's actions, bond yields
are far below their historical averages.
With the economy continuing to grow and the Fed gradually taking
its foot off the easy-money pedal, bond yields have nowhere to go
but up. That means that bond prices will fall.
The risks aren't confined to Treasuries. Junk bonds, which are
issued by companies that stand an above-average chance of
defaulting on their obligations, are perilously pricey. On average,
junk bonds yield only about 3.8 percentage points more than
Treasuries. Martin Fridson, a longtime junk bond analyst, says that
high-yield bonds have gone from "extreme overvaluation" to "very
Thanks to fears of deflation and the actions of central bankers
almost everywhere, yields are low across the globe. Portugal, which
appeared headed for default two years ago, now pays about 3%
interest on ten-year government bonds. Spain and Italy both pay
less than 2.5%--about the same, stunningly, as Uncle Sam pays on
Treasuries. Japan and Switzerland pay less than 1%.
Below are my picks for the best funds for this dangerous market,
listed from lowest risk to highest risk. To try to boost returns,
these funds delve into odd corners of the bond world. None takes a
conventional approach to bond investing.
FPA New Income (
) aims first and foremost not to lose money. Since FPA took over
the fund in 1984, it has never suffered a down year, although it
has lost money in about 15% of all months. Lead manager Tom
Atteberry has positioned the fund for rising rates. He owns a slew
of bonds and mortgage securities with below-investment-grade credit
quality. Average credit quality of the fund's holdings is triple-B,
slightly above junk status. The fund, which yields 3.5%, can expect
to lose a mere 1.5% of its value should bond yields rise by one
percentage point. Over the past five years, the fund returned an
annualized 2.2%, compared with 5.1% annualized for Barclays U.S.
Aggregate Bond index, which has benefited during a period of
generally falling yields. Expenses are 0.58% annually.
Metropolitan West Unconstrained M (
) takes a proven strategy and removes the risk (and the
opportunity) from falling yields. The fund's three managers have
successfully piloted Metropolitan West Total Return M (
), a more conventional bond fund, since 1997. Unconstrained invests
similarly--with one big difference: It sells some Treasuries short
to minimize interest-rate risk. If interest rates rise one
percentage point, the fund is positioned to lose only about 1% in
price. Unconstrained owns a stew of low- and high-quality corporate
bonds and mortgages. Average credit quality is double-B, putting
the fund's holdings in junk bond territory. Since its inception in
late 2011, the fund has returned an annualized 11.0%, compared with
2.4% for the Barclays Aggregate index. Expenses are 0.99% annually
and the yield is 1.8%.
RiverNorth/Oaktree High Income (
) is one of the few ways for individuals to access the junk-bond
expertise of Oaktree Capital Management, a highly regarded
institutional money manager. The fund invests three-fourths of its
assets in junk bonds and senior bank loans. The rest is managed by
RiverNorth, which invests in income-oriented closed-end funds
(closed-end funds trade on exchanges just like stocks). All told,
about 80% of the fund's assets are in junk-rated securities. The
fund would lose about 3% of its value if yields were to rise one
percentage point. It yields 4.0%. One big negative: Expenses are
high, at 1.60% annually. Since the fund's inception at the end of
2012, it has returned an annualized 7.3%.
Vanguard Convertible Securities (
) invests in hybrid securities that feature the attributes of both
bonds and stocks. Like bonds, they pay a fixed rate of interest.
But, as the name implies, convertibles can be converted into stock
at a preset price, so their value often rises and falls with
movements in the price of the issuing company's stock. Almost all
convertibles have junk credit ratings, but this fund has a nearly
unblemished record of avoiding bonds that default. Although the
fund's name doesn't say so, Oaktree manages Vanguard Convertible.
Over the past five years, the fund returned an annualized 13.8%.
Annual expenses are 0.63%, and the yield is a modest 1.9%. I really
like this fund, but it's about three-fourths as volatile as
Standard & Poor's 500-stock index, so this is hardly a low-risk
vehicle. You can only buy the fund directly from Vanguard.
is an investment adviser in the Washington, D.C., area.