Best of the Week
Most Popular
1.Crude Oil Price Trend Forecast 2016 Update - Nadeem_Walayat
2.Will Deutsche Bank Crash The Global Stock Market? - Clif_Droke
3.Gold Price In Excess Of $8000 While US Dollar Collapses - Hubert_Moolman
4.BrExit UK Economic Collapse Evaporates, GDP Forecasts for 2016 and 2017 - Nadeem_Walayat
5.Gold Stocks Massive Price Correction - Zeal_LLC
6.Stock Market Predicts Donald Trump Victory - Austin_Galt
7.Next Financial Crisis Will be Far Worse than 2008/09 - Chris_Vermeulen
8.The Gold To Housing Ratio As A Valuation Indicator - Dan_Amerman
9.GDXJ Gold Stocks - A Diamond in the Rough - Rambus_Chartology
10.Gold Boom! End Game Nears As Central Banks Buying Up Gold Mining Companies! - Jeff_Berwick
Last 7 days
Why Trump Will Win US General Election 2016 Prediction Forecast - 26th Sept 16
Martial Law Rolls Out Across the US As Jubilee Nears - 26th Sept 16
Stock Market More Correction Likely - 25th Sept 16
US Presidential Election Forecast 2016 - Trump Riding BrExit Wave into the White House - 25th Sept 16
US Economy GDP Growth Estimates in Free-Fall: FRBNY Nowcast 2.26% Q3, 1.22% Q4 - 24th Sept 16
Gold and Gold Stocks Corrective Action Continues Despite Dovish Federal Reserve - 24th Sept 16
Global Bonds: Why Our Analyst Says Things Just Got "Monumental" - 24th Sept 16
Where Did All the Money Go? - 23rd Sept 16
Pension Shortfalls Could Be 4X To 7X Greater Than Reported - 23rd Sept 16
Gold Unleashed by the Fed - 23rd Sept 16
Gold around U.S Presidential Elections - 23rd Sept 16
Here’s Why Eastern Europe Is Doomed - 23rd Sept 16
Nasdaq NDX 100 Big Cap Tech Breakout ? - 23rd Sept 16
The Implications of the Italian Banking Crisis Could Be Disastrous - 22nd Sept 16
TwinLakes Theme Park Summer Super 6 FREE Return Entry for Real? - 21st Sept 16
Has the Silver Bullet Run Out of Fire Power? - 21st Sept 16
Frack Sand: The Unsung Hero Of The OPEC Oil War - 21st Sept 16
What’s Happening With Gold? - 21st Sept 16
Gold vs. Stocks and Commodities, Pre-FOMC - 20th Sept 16
BrExit UK Inflation CPI, RPI Forecast 2016, 2017 - 20th Sept 16
European banks may be more important than the Fed this week - 20th Sept 16
Gold, Silver, Stocks and Bonds Grand Ascension or Great Collapse? - 20th Sept 16
Mass Psychology in Action; Instead of Selling Gilead it is Time to Take a Closer Look - 20th Sept 16
Hillary - Finally Well Deserved Recognition for Deplorables - 20th Sept 16
Fascist Business Model: Reich Economics - 19th Sept 16
Multiweek Correction in Gold and Silver Markets Continues - 19th Sept 16
Stock Market May Turn Ugly This Week - 19th Sept 16
China Is Digging Itself into a Deeper Hole - 19th Sept 16
Yellen’s Footnote 8 Would Put Interest Rates on Autopilot - 19th Sept 16
Central Bank Digital Currencies: A Revolution in Banking? - 19th Sept 16
UK Government Surrenders to China / France to Build Nuclear Fukushima Plant At Hinkley Point C - 19th Sept 16
Stock Market Correction Already Over? - 18th Sept 16
American Economics - 18th Sept 16

Free Instant Analysis

Free Instant Technical Analysis


Market Oracle FREE Newsletter

The Power of the Wave Principle

U.S. Bond Market Trouble Ahead

Interest-Rates / US Bonds Apr 19, 2013 - 08:40 PM GMT

By: Investment_U

Interest-Rates

Alexander Green writes: Warren Buffett recently opined that bonds should come with a warning label these days.

That is doubly true of most bond funds. Many investors are about to get steamrolled. But if you act now, you can avoid getting hurt.


Let me explain…

Historically, the best-performing bond funds have had one thing in common: low expenses.

For example, Vanguard’s fixed-income funds are routinely found in the top quartile of annual bond fund performance. Why?

Because, unlike stocks – where security selection is the key to outperformance – it’s tough to increase returns by picking individual bonds.

I’ll concede, however, that it is possible.

More than 30 years ago, Bill Gross and his colleagues at PIMCO pioneered a new approach to bond investing. Until then, a lender handed his money over to the borrower and then collected interest until the borrower repaid the loan.

The notion that anyone might routinely trade these instruments by selling them to others prior to maturity did not exist.

Gross recognized that opportunities exist to trade in and out of various sectors of the bond market – as well as individual issues – and moved to capitalize on this reality.

As a result of his expertise, the PIMCO Total Return Fund has outperformed through all market cycles over the long term. But Gross is often called “The Babe Ruth of Bonds” precisely because this is so darn hard to do.

Historically, the vast majority of fixed-income managers underperformed their unmanaged benchmark, like the J.P. Morgan Global Government Bond Index or the Barclays Capital Aggregate Bond Index.

But – surprising many analysts – this hasn’t been the case lately.

Hitting the Mark
Last year, for instance, 79% of intermediate-term bond funds – which hold a mix of government and corporate bonds maturing in five to 10 years – beat their benchmark. And over the past year, investment-research firm Morningstar estimates that long-term government bond funds beat their benchmarks by 2.5 points.

Wow.

Predictably, money is now cascading into actively managed bond funds as investors chase performance the ways dogs chase cars. (And with the same general results.)

Industry figures show that three-quarters of new fixed-income investments are going to bond pickers, not passively managed index funds.

Big mistake.

The hot bond funds are hot precisely because they are taking significantly more risk than the index funds.

Consider “duration,” a measure of a fund’s sensitivity to interest-rate changes based on the average maturity of the bonds it holds. As most bond investors know, you get a higher yield by owning longer maturities. So these bond fund managers have simply increased the average duration of the bonds in their portfolios.

This is all well and good as long as rates are steady or dropping, as they have been for the last 30 years. But when rates rise – as they inevitably will as the economy improves and the Federal Reserve ends its quantitative easing policy – these bonds (and bond funds) will get hurt much more than those with shorter maturities.

Dumb Moves
Another way bond managers goose returns is by buying “junkier” bonds. This too, of course, is riskier than owning bonds of higher credit quality.

And, thirdly, many bond managers are using leverage. That means they borrow money to buy extra bonds and thereby further increase yields. This is the equivalent of buying stocks on margin – and shareholders can expect the same result when the bond market sells off (which it will when interest rates rise).

In short, at the tail end of a 30-year rally in bonds – the longest and most massive in history – investors are piling into precisely the wrong investment. They are buying actively managed funds (with high expenses) that own longer maturities and riskier credits using leverage.

If you don’t understand what is going to happen here, visit your local old-timer and ask him what happened to his fixed-income portfolio in the early ’80s.

It wasn’t pretty.

And while it’s unlikely we’ll see the sort of hyperinflation that plagued investors three decades ago, bond fund buyers are in for a rude awakening when they see what happens to their supposedly “safe” fixed-income investments in a rising interest rate environment.

All fixed-income investors face an important choice. They can switch to low-cost, passively managed short-term bond ETFs and index funds, or they can stick with the active fund managers and learn the hard way.

The wise will opt for the former. As Ben Franklin said, “Experience is a dear school but fools will learn in no other.”

Good investing,

Alex

P.S. For those who depend on fixed income, I suggest you check out the work from my friend and colleague Steve McDonald. His strategy is truly the only safe way to navigate fixed income in our current interest rate environment

To view all of Steve’s work, click here.

Source: http://www.investmentu.com/2013/April/the-trouble-ahead.html

http://www.investmentu.com

Copyright © 1999 - 2011 by The Oxford Club, L.L.C All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Investment U, Attn: Member Services , 105 West Monument Street, Baltimore, MD 21201 Email: CustomerService@InvestmentU.com

Disclaimer: Investment U Disclaimer: Nothing published by Investment U should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Investment U should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Investment U Archive

© 2005-2016 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Catching a Falling Financial Knife