Maybe there's more to be worried about than the Boogeyman and the Big Bad Wolf.
The bond market has looked unflappable lately. The Fed raised short-term rates 17 times from mid-2004 to mid-2006, but investors--apparently more focused on rates' low overall levels and on steady, if slower, U.S. economic growth--have barely flinched. The market has also proved resilient to individual disruptions that might have had more serious repercussions in years past. Risk in emerging markets was a worry last May and June, but some of the hardest-hit bonds, such as Turkey's, quickly rebounded. As another sign of investors' Pollyannaish mind-set, Bloomberg News ran the headline "Thai Coup Good for Bonds" a few weeks after a military coup in Bangkok. Finally, although it certainly has become more difficult for low-income borrowers to qualify for home loans, the worsening U.S. subprime mortgage situation does not appear to have led to wider problems for the bond market in the past two-and-a-half months.
When conditions are as tranquil as they have been, it makes sense to wonder whether the good times will last. Riskier areas of the bond market have rallied very hard, resulting in valuations that are rich by historical standards. Adverse events could lead investors to reassess their collective appetite for risk. Below, we discuss the worries of some of the bond market's best minds and how they are trying to protect their investors if a shoe or two happens to drop. Some of these funds have suffered recently, at least as far as relative returns are concerned, but that's a logical result of their conservative steps. More importantly, these offerings should be in good shape to thrive if and when a broad market shift takes place.
The list isn't comprehensive, but it does give a pretty good idea of some of the primary concerns we've been hearing lately.
Dodge & Cox Income
This fund has always been mild mannered. It avoids sizable interest-rate bets and big positions in junk bonds. Lately, the fund's managers have thought that market yields seemed too low, though, and factors such as inflation and the weak dollar could lead to higher rates three to five years out. Therefore, they have taken less interest-rate risk than peers have, sticking nearly 60% of assets in bonds maturing in one to five years. And, although the bosses continue to find ideas aplenty in the corporate-bond sector, they've been working hard to sidestep its increasingly many landmines. Higher-quality issuers can be targets for private-equity firms, who finance deals by piling debt on acquiree's capital structures. These transactions (known as leveraged buyouts) impair the values of existing bonds. The long-term-thinking Dodge & Cox team is therefore fixed on finding companies that can fend off these assaults and avoiding likely buyout candidates.
FPA New Income
There's cautious, and then there's FPA New Income. More than just about any managers out there, comanagers Bob Rodriguez and Tom Atteberry don't want to lose investors' money. Potential antagonists today include higher inflation, thanks to rising energy prices, and a weakening domestic economy, due to a housing bust. Like the Dodge & Cox crew, Rodriguez and Atteberry aren't convinced that Treasury bond yields are high enough to compensate them for these risks. However, they've kept the fund's duration, a measure of a portfolio's interest-rate risk, much shorter by sticking a big slug of assets in cash. They're almost completely out of corporate bonds, too, as, in general, the yields on these bonds are only marginally higher than Treasuries'. There has been a cost to these bearish moves, as the fund has lagged its peers in recent years, but it hasn't lost money in a calendar year in three decades.
Metropolitan West Total Return Bond
The principals at Met West may not be as leery, but a few things seem to be causing sleepless nights in their homes. They, too, expect the economy to soften, handcuffing companies' abilities to deliver impressive profit growth. They haven't given up on corporates the way that Rodriguez and Atteberry have, but they've reduced their stakes more than the Dodge team has, and they've taken other steps such as moving away from high-yield bonds. They've also emphasized safer industries, such as REITs and insurance, and structures, such as aircraft-backed instruments. The shop's track record isn't blemish-free, as its funds got stung by a few sour corporate-bond holdings in 2002. Maybe losing money back then has made the decision-makers at the shop even more focused on preventing similar situations from happening again, though.
PIMCO Total Return
Something about living and working in California, as these managers do, must be making folks gloomy. Bond giant PIMCO (of Newport Beach in Orange County) and Bill Gross are also worried about housing and its impact on the economy. In their view, tightening lending standards and increased regulation are signaling an end to the good times that homeowners have enjoyed in recent years. Gross and PIMCO don't see corporate bonds (including high yield) as a good place to be, given this scenario, so Total Return's stake in these bonds was recently less than 5% of assets. Like the other chiefs above, they have preferred high-quality mortgage-backed bonds, which offer decent yields and less risk. But PIMCO is more convinced than the others that the Fed will have to lower rates, and relatively soon, to prevent a calamity in the property market. To capitalize from this eventual easing, they're taking on more interest-rate risk than peers are.
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