The Bond Bear Market And Your Portfolio

The 21-year party in treasury bonds is over for at least a couple of years. The first phase of the bond bear market probably ended in mid-August. But there is more to come.

Investors must adjust to the new bond market. Capital gains from income investments will be few and far between. Safety and income should be the key goals. Secure the best yield you can without risking losses.

We were fortunate to have anticipated the bottom in interest rates. We reduced treasury bond and GNMA holdings last year. We established sell signals on many of the income funds in our Managed Portfolios, and most of them were triggered in July or early August.

Now, it is time to plan strategy for the new bond and income investing market. As I said earlier, rates rose too far, too fast. They might decline a bit from the August highs. Don’t view that as a new bond bull market. It will be temporary until strong economic growth takes hold.

Avoid the temptation to chase higher yields in this market. Higher yields means higher risk, and I think those risks will be realized in the next year or two. It is not worth giving up a margin of safety to earn a higher yield now.

That means don’t buy long-term bond funds for their higher yields. Check the duration of a fund’s portfolio. If a fund’s duration is 4.6 years, if rates rise one percentage point the portfolio will decline 4.6%. Duration and its effects are good reason not to “go long.” Duration is available on a fund’s web site, in Morningstar publications, and by calling the fund.

Here are a few other choices to avoid right now.

Preferred stock is good only if you buy individual shares and hold them until called. Most closed-end mutual funds that concentrate in preferreds now sell at premiums to their net asset values.

Bank debt, or prime loan, funds and utility stocks and funds have low yields for the risks they carry. I’d avoid them.

Now, let’s discuss our specific portfolios. This month, we’ll start with the Income and Income Growth Managed Portfolios.

Income

Our Income Managed Portfolio moved into money market funds over the last month as sell signals were triggered in Fremont Bond, Dodge & Cox Income, and Price High Yield.

Our strategies will be to shorten maturities in bonds and to seek income sources that aren’t closely affected by interest rate changes.

The foundation of the Income Managed Portfolio now will be short-term bonds, especially corporate bonds. Short-term bond fluctuate less with interest rate changes, as do corporate bonds. In addition, as interest rates rise a short-term bond matures sooner so the principal can be invested more quickly in higher-yielding maturities.

The only pure short-term corporate bond fund is Vanguard Short-Term Corporate Bond. It also has the advantage of being no load and having Vanguard’s ultra-low expenses. Its current yield is between 3% and 4%. That is comparable to yields on intermediate treasuries without as much interest rate risk.

Fidelity Short-Term Bond also invests solely in corporate bonds, though its performance has been below Vanguard’s in both the long-term and in recent years. Alternative funds, none of which are pure corporate funds, are TIAA-CREF Short-Term Bond and Price Short-Term Bond. TIAA-CREF has the best performance of the group in recent years, but that is due to its much higher treasury holdings.

I’m also recommending TIPS (Treasury Inflation Protected Securities), also known as inflation-indexed bonds. The principal of these bonds automatically is adjusted for increases in the Consumer Price Index annually, though interest payments do not change. Investors are protected from inflation, which is the major fear of most bond investors. The yield is a bit lower than for regular treasury bonds.

The principal adjustment is treated as a taxable payment in the year of adjustment. Some advisors believe this means TIPS should be purchased only through tax deferred accounts, but I see no reason not to buy through taxable accounts. Just be sure you are prepared to pay the tax bill on the adjustment each year.

Funds investing in TIPS, frankly, did poorly in the early-summer debacle. I expect that they will do better in the next one to three years when interest rate increases are likely to be due to inflation and inflation fears. Vanguard, Fidelity, American Century, and PIMCO offer TIPS funds. Vanguard has the lowest expenses, and American Century’s is in most NTF programs. Vanguard Inflation-Protected Securities will be the recommended fund in the portfolio.

Also in the portfolio will be Cohen & Steers Realty Shares. This fund of real estate investment trusts (REITs) had a yield of over 5% recently and has the potential for capital gains as the economy improves. I think that REITs are fairly valued to a little undervalued right now, especially the quality REITs this fund purchases. You might see reports of REITs in general being overvalued. Those reports include the higher-yielding aggressive REITs that yield-chasing investors overpaid for in recent years. Quality REITs pay solid yields and trade at reasonable values. A big advantage of REITs is that their yields are likely to increase if the economy grows.

REITs also have the potential to generate capital losses if the economy slows down or declines. I consider that a low risk right now, but we’ll put a sell signal in place as a precaution.

The firm has a higher-yielding fund, Cohen & Steers Equity Income. The loads and expenses are too high, however, for me to recommend.

The detailed allocation and sell signals are on page 10. This portfolio should pay a solid yield and have a fairly stable value in the turbulent bond market ahead.

Income Growth

All of this Managed Portfolio’s holdings except Cohen & Steers Realty Shares had their sell signals triggered in the last month. As with the Income Portfolio, we’ll make short-term corporate bonds, TIPS, and CSRSX the foundation of the portfolio. The mix will be different, as detailed on page 10, because we are seeking growth of income in this portfolio.

I’m adding a balanced fund to this portfolio. A combination of high-yielding stocks and corporate bonds selected by seasoned analysts will result in higher income and some capital gains. My top choice is Dodge & Cox Balanced. A good alternative is Vanguard Wellington.

Sector

The sell signals for the bond funds were triggered in the last month. Since the bond bull market is over, we’ll have more of a margin of safety with no bonds in this portfolio for a while.

The biggest risk we have in the Sector and Balanced Portfolios is the calendar. We’re entering the time of year in which the markets tend to perform their worst. When all other things are equal, September and October are when the markets are most likely to take a dive. All other things are not equal this year. Interest rates are on the rise, and the economy is balancing between a strong recovery and continuing sluggish growth. Stocks quickly moved from undervalued to much higher values and have been stalled since June.

The first thing we will do is increase the holdings in Cohen & Steers Realty Shares. REITs tend to perform the opposite of stocks and bonds. So CSRSX provides good diversification and balance. The fund also should provide a good yield and continue growing as the economy grows.

The main threat to this fund, a second recession, is unlikely. A longer-term threat is that economic growth continues to be sluggish. In that case, office vacancies will not be reduced and might even grow. Rents also would not grow and might decline. I do not anticipate the economy being that sluggish. But we’ll keep a sell signal in place as protection.

We’ll also add to Hussman Strategic Growth. The fund buys growth stocks that are selling at discounts according to its models. In addition, the fund will hedge its portfolio against market declines when its models indicate the market is due for a tumble. Recently, the fund was 30% to 50% hedged. That means the fund is poised for gains if the market rises and has strong protection if the market declines. That’s a margin of safety I like.

TCW Galileo Select Equity is our top performer in the market rally. It is invested in market-leading technology and other growth stocks. Many of these stocks had strong runs in the rally and could be due for serious corrections. For now, we’ll hold the fund but keep a careful eye on the sell price on days when the market indexes are declining.

I’m closely watching AXA Rosenberg Global Long/Short Equity. One of the fund’s strategies is to sell short highly valued stocks. Those stocks were the rally’s leaders, making the short sales losers. The fund should provide diversification and protection if the market heads south, so we’ll keep it for now.

In coming months we might sell RMSIX in favor of two appealing opportunities.

The most undervalued investment on the globe still looks like small international stocks, especially European stocks. We invested in these about a year ago but our sell signal was triggered in the general market decline last fall. The stocks have done well since the recovery but still could have a long way to go.

I also like small cap value stocks in the U.S. market. Merger and acquisition activity is rising, and smaller companies are those most likely to be purchased at a premium. The small growth stocks are too overvalued, so we’ll look at value funds.

For now, I’d like to see the markets get through this difficult period. One recent warning flag was the shareholder report from Longleaf Partners. I respect this management a great deal, and they report difficulty finding values. They are selling stocks that have done well and raising cash. When Longleaf Partners is having trouble finding values, we should be cautious.

Balanced

In this Managed Portfolio I’m recommending the same funds as in the Sector Portfolio but in different allocations. See page 10 for details of all the recommended allocations, including the sell signals.