Navigating the Market

Most advisors will prefer to utilize funds instead of individual bonds.  However, as the tables at the end of this article illustrate, high-grade bond funds yield noticeably less than individual bonds. 

But funds offer many advantages over individual bonds. According to Loomis Sayles’ Stokes, “for the average investor it is more appropriate to buy a fund because it provides immediate diversified exposure, liquidity, the benefits of getting in at real market levels (instead of paying up to do odd lot trading), and a team of resources to watch the credits as we weave our way through a difficult economy.”

Advisors should note several points about the high-grade bond funds and ETFs listed below.  First, none provide exclusive exposure to the high-grade corporate market.  The exposure among bond funds ranges from 11.4% to 75.1%.  To the extent that these funds own Treasury and mortgage-backed debt, yields will be lower.  Second, historical performance – specifically, year-to-date performance – is not a useful guideline in selecting funds.  These funds all held high-grade bonds earlier this year, and would have experienced poor performance as spreads widened.  Recent past should not be the yardstick for gauging future performance.  These funds may shift maturity and credit exposure as opportunities change.  The only way to be assured of capturing the yield to maturity in today's market is to hold bonds individually.  Lastly, consider our list of ETFs as a starting point for future research.  Adivosrs will need to explore the indices on which these ETFs are based and the degree to which they capture exposure to the high-grade market.

We asked Stokes about the 53.6% exposure to investment grade debt in Loomis Sayles’ Investment Grade Bond (LIGRX) fund.  She said that, on the margin, she expects that exposure to increase. She added that, “as this credit crunch develops, a broader and more diversified number of fixed income issuers are starting to trade at very attractive prices. Investment grade corporate bonds were the second leg to fall after the securitized market; now high yield, emerging markets, non-US dollar, and convertible markets are repricing themselves.”

For retirement portfolios with long term time horizons, a decision to go into high-grade bonds should be based on a belief that the crisis is correctable over the next year or two. 

The safest, least volatile plays are short-term.  But if you believe conditions will start to improve over the coming year, you may wish to go into longer maturities to lock in these ostensibly rich yields.  But leave some powder dry.  Markets typically bounce around their lows before recovering in earnest, so we could see even greater bargains over the coming months.  The standard rules of diversification still apply.  Choose a range of industries that offer essential products and services that will continue to generate sufficient free cash flow during a recession.  Ladder the portfolio with varying maturities to balance performance. 

But the real opportunity today is in income portfolios for clients who, for example, may be at or beyond retirement age.  Funding these portfolios, at least in part, with high-grade bonds at today’s yields deserves serious consideration.  In this case, the expectation is that the bonds will be held to maturity.  The primary risk is inflation or hyperinflation (which would decrease the purchasing power of future coupon payments), and this risk can be mitigated by including TIPS in the same portfolio.  Especially if individual bonds are used, the risk of default must be assessed.  Bond defaults imply bankruptcy, and it is unlikely that issuers like Goldman Sachs will not be around in 10 years.  But we’ve seen some pretty crazy things happen this year.

Stick with senior, high quality bonds.  There’s already enough yield and risk in the bond market, and there’s no need to shoot for extra income by venturing lower down the capital and rating structure.

Our final thought regards the credit ratings agencies.  You cannot rely on their guidance.  At best, consider their grades a starting point for your own research, mindful that an issuer’s name is no longer assurance of future performance. 

Sample of Investment Grade Bond Funds

Source: Morningstar as of October 27, 2008

Source: ETF Trends, Morningstar, as of Oct 27, 2008

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