Even in a tumultuous environment, investors almost always can make money in bonds.
Equity-fund managers are fond of saying “It’s not a stock market, it’s a market of stocks,” but the same can be said for bonds. Even though the term “bond market” often lumps all areas of the fixed-income universe, there are always plenty of opportunities to pick up added return by moving among different market segments — even when rates are rising.
That’s especially true right now. Even though broad-based index funds are on track to finish with their second consecutive quarter of weak returns, there were some critical differences between the second and third quarters — and these differences might just hold the clues to what investors can expect in the months ahead.
Why Q3 Was Nothing Like Q2
The key distinction between the two intervals was the performance of the credit-sensitive segments of the market.
In the second quarter, bonds were hit hard virtually across the board. The Barclays Aggregate Bond Index was hit for a loss of 2.33%, with long-term bonds, municipals and emerging-market debt all performing much worse. When the dust settled, all segments of the market closed the quarter in the red.
Even senior loans, the best-performing sector, still lost 0.28% based on the return of the PowerShares Senior Loan Portfolio (BKLN).
In contrast, underperformance in the third quarter has been contained to areas of the market that were most directly affected by the prospect of tapering: government debt and other rate-sensitive segments. The Vanguard Total Bond Market ETF (BND), which tracks the Barclays Aggregate, had returned just 0.47% quarter-to-date through Tuesday — indicating that all of its return was from coupon — while the iShares 20+ Year Treasury Bond ETF (TLT) was sitting in the red with a 2.56% loss. High-grade corporates and municipal bonds also have been soft amid the questionable outlook for rates.
It’s here that the comparison between the two quarters ends.
Whereas even credit-sensitive market segments lost ground in the second quarter, they have all rewarded investors with strong returns in the past three months. In an environment highlighted by low investor risk aversion and the prospect for improving global growth, high-yield bonds, senior loans and emerging-market debt have all excelled. For instance, the iShares High Yield Corporate Bond ETF (HYG) has gained 2.97%, well above the returns of the investment-grade market, while SPDR Barclays High Yield Bond ETF (JNK) was just slightly below that at 2.85%.
Indeed, the further investors went out the risk spectrum in the third quarter, the better off they would have been. Consider that some of the best-performing ETFs were those invested in corporate and high-yield debt overseas — segments that also gained a boost from the sinking dollar:
SPDR Barclays Capital International Corporate Bond ETF (IBND): 5.29%
iShares Global High Yield Corporate Bond Fund (GHYG): 3.57%
WisdomTree Emerging Markets Corporate Bond Fund (EMCB): 2.91%
iShares Emerging Markets High Yield Bond Fund (EMHY): 2.01%
This stands in marked contrast to the second quarter, when taking on added risk in any form would have led to extremely poor returns. These divergences indicate that investors are now becoming much more discerning in their approach to bonds, eschewing areas with interest-rate risk but embracing those that are in the best position to benefit from the improving economic outlook.
What Does This Tell Us About the Future?
The key takeaway here is that the bond market has plenty of places for investors to make money, even in a tough environment. While the primary risks to the interest-rate outlook — tapering — has been kicked down the road for now, it will almost assuredly crop up again as an issue within the next six months.
As a result, investors are likely to be better off avoiding the most rate-sensitive investments in favor of those with greater credit risk (sensitivity to risk appetites and economic conditions.
In this sense, all of the areas I cited in December in my article “The Best Bond ETFs for 2013” — short-term high yield, international corporate debt, and target maturity corporate and high yield bond funds — can continue to be a source of incremental return in the months ahead. And if yields do in fact fall, these segments are likely to perform even better.
The outperformance of credit-sensitive segments can continue as long as the current environment remains in place, but investors need to be aware of two important risk factors.
First, any segments with elevated credit risk are vulnerable to adverse headlines. And there could be plenty of these on the way, with the continuing budget resolution and debt ceiling battle both on tap within the next four weeks. If these disruptions lead to a renewed selloff in risk assets, consider it a buying opportunity. While the prospects of a compromise appear bleak right now, they were equally so prior to the high-profile budget agreements in August 2011 and December 2012. If anything, disruptions caused by political noise would be a chance to add to these segments when yields are elevated.
The second issue — the outlook for global growth — is a longer-term consideration. For these segments to continue their recent strength, economic data needs to keep improving and/or exceeding expectations. (In the case of high yield and senior loans, domestic economic data is key; for the emerging markets, global growth is the critical factor). Any sign that the recent uptick has been a mirage would indeed change the equation for credit-sensitive assets and be an indication that it’s time to pare back on risk.
The Bottom Line
The “bond market” might still be unsteady, but that doesn’t mean investors can’t take on risk. In this case, it’s the type of risk that counts.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.