BondsOnline Advisor

Three Ways to Play Uncertainty

by Stephen Taub

So, how high will bond yields rise this year?

Not even the pros can agree. According to a recent Bloomberg survey, predictions for the year-end yield of the two-year note range from a low of 2.9 percent forecasted by HSBC to as high as 5.25 percent projected by Bear Stearns.

On the 10-year note, HSBC is looking for just 4 percent while CIBC is figuring 4.05 percent.

However, at the high end of the range, Bear Stearns is looking for 5.75 percent while J.P. Morgan Chase thinks it will top 5.8 percent.

Like I said: Even the pros don't really know.

With such wide disparities like these, what are investors to do? Well, it all depends upon their own convictions and risk tolerance.

One school of thought is to stay short—Treasury bills, money market funds, short-term notes and ultra-short-bond funds.

Morningstar recently offered three suggestions for investors willing to take a little more risk. However, the recommendations—clearly a cross section of fixed-income worlds-- came with this caveat: The fund-rating firm warned it can "find something critical to say about nearly every corner of the bond market right now."

Fidelity Floating Rate High Income

This $2.3 billion in assets fund specializes in bank loans, which account for about 80 percent of the total portfolio.

"Of all the options that bond investors have to fight the fear of rising rates, bank-loan funds are matched only by money market funds for resistance to the problem," Morningstar asserts.

Yields on these funds behave similarly to short-term funds. However, because they are credit-sensitive, they typically pay a lot more than money markets.

What's more, they "can even generate some capital appreciation if a thriving economy helps shore up the health of underlying issuers," Morningstar adds.

The research firm does point out that it could be a little late in this game if you want to make a fair amount of money from capital appreciation. "The hope with this fund, therefore, is that its fairly conservative nature, compared to more yield-hungry, aggressive bank-loan funds, should offer some protection against any credit-driven sell-off. Plus, it offers terrific protection from rising rates," it adds.

Its expense ration is 0.84 percent and the minimum investment is $2,500. As of the end of January, the fund's yield was 3.23 percent.

American Funds High-Income Municipal Bond

This fund is decidedly different from the bank loan fund. As its name implies, this portfolio is filled with high-yield municipal bonds.

Last year, its total return was 5.7 percent. And believe it or not, it recorded the exact same return for each of the three prior years—up 6.2 percent. In each of those years, the fund, which has $1.5 billion in assets and an expense ratio of 0.74 percent, did slightly better or slightly worse than the other funds in its category.

"This fund has a really nice record of keeping trouble at bay, and we're particularly assuaged by the overall quality of American Funds' managerial and analytical staffs," says Morningstar. "And given that high-yield muni funds ply the Wild West neighborhood of bonds that lack third-party ratings, such considerations--as well as a need for tremendous trust--are not trivial."

Morningstar explains that investors may like this fund at this point in the interest-rate cycle because mid- and lower-quality munis tend to be resistant to rising rates. Part of the reason is the cushion provided by their relatively generous income payouts.

It also points out that these kinds of muni bonds invariably trade much less frequently than more well-known, highly-rated issues. "As such, their prices can prove quite steadfast, unless there's a notable credit event that convinces the pricing agencies to make a change," it adds.

Another appeal of high-yield munis is that unlike taxable junk bonds, and even bank loans to some extent, these bonds have not been bid up as much by yield-chasing investors. Indeed, its current average yield is around 4.41 percent.

Morningstar points out that credit quality has remained fairly good, but warns investors not to discount the considerable risk of owning mid- and low-quality munis.

T. Rowe Price International Bond

This fund is more of a bet on a continuingly weaker dollar, Morningstar stresses.

"Nobody should buy this fund thinking that it's a substitute for a plain-vanilla bond fund," it stresses. Rather, it says the fund is a way to get some exposure both to non-U.S. bond markets and currencies. "The fluctuations of the latter can sometimes prove a lot more vicious than investors expect," it adds.

Global bond funds were the ones to own earlier in the decade; T. Rowe Price International returned nearly 22 percent in 2003 and nearly 19 percent in 2003, before "falling off" to 11.4 percent last year. So far, the fund is down more than 1 percent year-to-date.

Keep in mind that it also has an expense ratio of 0.91 percent.

In addition, Morningstar warns that the fund's three-year standard deviation is about 30 percent higher than that of the most volatile offering in the company's intermediate-term bond category, where most core bond-fund offerings reside. It adds, "Tread here if you must, but tread carefully."
 

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.