Will Bond-Fund Investors Suffer More Pain?

Interest rates and inflation are on the rise--and that’s no surprise to Bob Rodriguez. A year ago, the two-time winner of Morningstar’s Manager of the Year award decidedthat inflation was significantly understated and a blossoming economy would mean a sharp spike in interest rates. Put another way, if you subtracted the true inflation rate from the yield on most government debt, you would barely have a nickel left over, according to Rodriguez's thinking.

While most bond-fund managers might slightly reduce the duration (a gauge of interest-rate risk) of their portfolios when faced with this outlook, Rodriguez took aggressive action. He declared a buyers’ strikeon long- and intermediate-term government debt and brought  FPA New Income’s (FPNIX) duration all the way into short-term territory.

Rodriguez hates to lose shareholders’ money, so if bonds aren’t offering a decent margin of safety, he’ll retreat into cash-like instruments until rates rise. This means the fund sometimes gets stuck in the mud during rallies, but this stance has also enabled it to finish every calendar year in the black. Rodriguez’s latest move has paid off handsomely. The average intermediate-term bond fund has lost 1.32% for the year to date; however, FPA New Income is up 1.33%, thanks to its low duration and some interest-only instruments. That’s a huge performance gap in the bond world. Bold moves like these have earned the fund outstanding long-term returns, too.

As you've probably figured, the latest rate spike doesn’t impress Rodriguez. Though the 10-year note’s yield is up to about 4.80%, Rodriguez says he probably won’t buy until it reaches about 5.5%. Moreover, he expects that he’ll get that chance in a year or two. In the meantime, he’s pegged the fund's duration at just 1.15 years.

Why so bearish? It starts with Rodriguez’s belief that inflation has been significantly understated by the consumer price index (CPI). He cites health-care costs as an example. While they’re rising at double-digit rates and account for 15% of total economic spending, they only account for 6% of the CPI. Rodriguez says inflation in housing is also underestimated because the CPI gauges rental rates rather than home prices. Low interest rates have led more Americans to buy homes, and that, in turn, has led to higher home prices, but subdued rental rates.

Further, Rodriguez sees a strengthening U.S. economy--which will add to inflation pressures--yet a Federal Reserve that will be too slow to put the brakes on the bond-market bubble, just as it was too slow to try to stop the stock-market bubble in 1999. He notes that American consumers now have a record amount of debt that adjusts to interest rates, and therefore believes the Fed is reluctant to inflict pain on consumers by aggressively raising rates.

What about TIPS (Treasury Inflation Protected Securities)? Nope, Rodriguez doesn’t like them right now either. A few years ago, they were priced for extremely low inflation so that even a small uptick would make them a good deal. But now they’re pricey, and that means they are behaving a lot like straight bonds. Rodriguez points out that TIPS lost nearly as much as other Treasuries in the latest sell-off, while they only had about one third the downside in previous sell-offs. FPA New Income has about 10% of its assets in TIPS, but these assets are in issues that mature fairly soon and therefore are just slightly more volatile than T-bills.

So Rodriguez waits patiently, though he knows he’s sticking his neck out. “If I’m wrong, then my shareholders will lose an opportunity return, but they’ll still earn a positive return. However, if we’re half-right, then most bond funds will lose money and we’ll hold up better than most.”

Poll Results
Last week I asked which international fund was the most overrated, and this is how you voted.
    7.07% - American Century International Growth INV TWIEX
    9.38% - Fidelity Overseas FOSFX
    78.0% - Janus Worldwide JAWWX
    5.76% - Thornburg International Value A TGVAX

The previous week I asked: If a fund you owned permitted market-timing that cost shareholders money, what would you do? Here's how you voted.
    2.31% - Buy more
    79.3% - Sell
    18.5% - Hold