Is it time to sell bonds?

St. Louis Post-DispatchJanuary 5, 2013 

— Scott Colbert is a smart bond guy. His Commerce Bond mutual fund has beaten its index for one-, three-, five- and 10-year periods.

But these days, he’s down on his bread and butter.

“I just sold my bond fund in my 401(k),” he told hundreds of the Commerce Bank customers at an economic forecast breakfast in Clayton, Mo.

Colbert likes the fund he manages, of course. It’s the bond market he worries about.

Yields on domestic taxable bonds are now so pitifully low, he says, that there are better options for income-lovers willing to crawl out a little further on the limb.

The iShares Core Total U.S. Bond fund, which tracks all American investment-grade bonds, yields 2.4 percent – a hair above inflation. A comparable intermediate Treasury fund would yield about 1.6 percent, and a corporate bond fund, 3.7 percent.

Among Colbert’s favored alternatives are dividend stocks, certain preferred stocks, emerging market bonds, and floating-rate bank loan funds. Lots of common stocks have dividend yields higher than bonds these days, he notes.

Those things, of course, are riskier than bonds, notes Eric Kelley, director of fixed income investment at UMB Bank. Boring government and investment-grade bonds serve as a parachute to ease your descent when the bottom falls out of riskier markets. So you should never dump them completely. Kelley worries that conservative bond investors who stray too far may be shocked at the wild drops that other investments can bring.

You don’t have to decide tomorrow. Rising interest rates and inflation are the main enemies of bond investors in a recovering economy. Those monsters seem likely to remain caged for the next several months at least.

So, bond investors can probably count on collecting their measly interest income with little short-term worry. But absent a big economic shock, they’ll see little of the price gains that propelled the bond market for the past three years.

Municipal bonds

Scaredy-cat investors in high tax brackets should consider municipal bonds, Colbert and Kelley say. Muni yields haven’t fallen as far as corporate and government bonds, and they still offer decent value. Intermediate-term muni funds yield about 3 percent.

But watch the headlines. Muni interest isn’t subject to federal income taxes – a big advantage. It’s possible that rich folks might lose part of that break during the “fiscal cliff” negotiations. That could trim muni prices.

Colbert, director of fixed income investing at Commerce, thinks stocks offer better value today and will for years to come. The S&P 500 Index of big-company stocks yields a 2.2 percent dividend – nearly as much as the broad bond market – and stocks are a much better bet for price appreciation. General Electric’s 3.6 percent stock dividend equals the yield on its 10-year bond.

Colbert also likes some preferred stocks, such as Bank of America perpetual preferred series L (symbol BAC-pl), yielding 6.4 percent. Preferred stock pays a high dividend but has no voting rights, and the dividend can be suspended if the company gets in trouble.

At the Moneta Group in Clayton, Chairman Don Kukla uses a form of alternative mutual fund that uses hedge fund strategies, but tries to limit risk and volatility. He likes AQR Multi-Strategy Alternative Fund (year-to-date return 1.7 percent) and AQR Managed Futures Fund (1.9 percent for the year). The funds take long and short positions in the bond, stock, commodities and currency markets.

Despite weak performance this year, Kukla thinks they should outdo bonds without excessive risk over time. They’re fairly new funds, although the management company has a track record, and their expense ratios are high – 2 percent for the multistrategy fund and 1.5 percent for the futures fund.

‘Junk bonds’

Kelley thinks the U.S. high-yield market – known as “junk bonds” to the common investor – is still a decent buy, although it’s had quite a run. By contrast, Colbert likes to journey overseas for extra spice. He likes PIMCO Emerging Markets Bond fund, yielding 3.9 percent.

Consider bank loan funds, Colbert says. They invest in loans to companies too weak for an investment-grade rating. But the loan rates are tied to an index, and they’ll rise when interest rates finally take off.

That gets us to the midterm risk facing bond investors: Bond prices fall when interest rates rise. And rise they will, eventually. An intermediate-term bond fund might lose 5 percent of its value if interest rates rise 1 percent. The loss would more than erase a year’s interest yield.

The Federal Reserve seems determined to keep a lid on both short- and long-term rates through next year and beyond. Barring a surprise jump in inflation, the Fed says, it won’t lift the lid until unemployment nears 6.5 percent. At the current pace, we’ll get there in late 2014 or 2015.

But the bond market tends to anticipate things. If economic growth picks up, traders could start pushing long-term interest rates up late next year, Kelley says, leaving the Fed to decide whether it will keep pushing down.

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