While everyone’s eyes have been fixed on the government shutdown and looming debt ceiling deadline, the bond market has been making some subtle moves.
The September announcement by the Federal Reserve that it is full steam ahead on their asset purchase programs caused a snap-back rally in nearly every fixed-income sector. Prior to that event, interest rates had been on a meteoric rise that rivaled any such bond market volatility since the mid-1990s.
Now we’re starting to see some semblance of order return to bonds, but figuring out how exactly to attack it must be a nuanced decision. Each sector of the bond market offers its own unique opportunities and risks — and here, we’ll analyze four segments to see which bonds are offering the best value right now:
#1: High Yield Continues Its Hot Streak
One area of the bond market that has been on fire this year is short-duration high-yield bonds, which have continued to crank out substantial income with low volatility. One of my favorite ETFs to access this space is via the PIMCO 0-5 Year High Yield Bond ETF (HYS), which currently is trading near its 52-week highs. The current yield on this ETF is 3.5%.
The advantage of choosing shorter-duration high-yield bonds is that you are further insulated from interest-rate risk in the event that we see another move higher in bond yields. The greater danger to this sector is a stumble in the economy, which would deteriorate the credit fundamentals of the companies that issue high-yield bonds.
That is why I am avoiding longer duration securities such as the iShares High Yield Corporate Bond ETF (HYG). Right now, the higher yield (5.3%) doesn’t match the risk of more substantial price decline should this sector fall out of favor.
#2: Mortgage Bonds on the Move
Click to Enlarge One of the first areas of the market to begin warning us of potential danger back in May was mortgage-backed securities.
The iShares MBS ETF (MBB) is one of the larger proxies for this market, with more than $15 billion in total assets. The bonds held within this portfolio (along with Treasuries) are some of the very securities the Fed has been buying to keep interest rates artificially low.
Since the September decision by the Fed not to taper asset purchases, MBB has been off to the races and is now trading very close to its long-term 200-day moving average. If this fund can climb above that technical level, it might set the stage for a larger comeback in mortgage securities that would lure additional money back into this space.
I typically prefer to play this sector through the expertise of an active manager such as the Doubleline Total Return Bond Fund (DBLTX). I have found the expertise in research, security selection and risk management to be well worth the slightly higher management fee. Meanwhile, it yields 4.6%.
#3: Municipals and Emerging Markets Snapping Back
Two of the most beaten-down sectors of the bond market this year have been municipals and emerging markets.
Municipal bonds garnered negative headlines this year on the back of a bankruptcy filing by the city of Detroit. That — combined with the headwind of rising interest rates — set this sector back significantly. Meanwhile, emerging-market bonds were dumped largely because of the poor performance of both equities and currencies in underdeveloped overseas markets.
But the biggest decliners often are the ones that snap back the hardest.
Consider that the iShares National Municipal Bond ETF (MUB) and iShares Emerging Market Bond ETF (EMB) jumped 2.8% and 3.2% respectively in the month of September. Performance like that is typically reserved for equity-like positions. Both of these ETFs carry an effective duration of more than seven years, which contributed to the push higher when interest rates fell last month.
Right now, I am avoiding exposure to these sectors and sticking with fixed-income holdings that offer better relative performance and shorter durations. I would use this short-term strength to sell any lingering exposure and rotate into more defensive holdings.
#4: Convertible Bonds Stealth Advance
One sector of the bond market that hasn’t received a great deal of attention lately: convertible bonds. These hybrid instruments carry characteristics of both equities and bonds by giving a bond holder the option to swap for common stock at a specified strike price.
The SPDR Barclays Convertible Bond ETF (CWB) has been on a stealth climb higher since the beginning of the year, and with very little relative volatility. According to Index Universe, this ETF has added more than $600 million in new assets and posted a total return of more than 14% for 2013.
Right now I only have limited exposure to this sector through the actively managed Osterweis Strategic Income Fund (OSTIX), which carries a small slice of convertible bonds. However, I am wary about allocating additional money near the highs right here. I would rather wait for a pullback to enter an exchange-traded fund such as CWB that has specific exposure to this sector.
The caveat will be that the market can withstand the current political turmoil and finish the year strong. If we see a deterioration of economic fundamentals, convertibles might get dragged down into the mud with stocks.
The Final Word
No matter how your portfolio is currently positioned, remember to check in regularly on your fixed-income holdings to ensure they are providing you with adequate income and protection vs. their peers. Often times it is very easy to switch to a comparable fund with a lower duration or another sector that is performing much better.
I don’t subscribe to the theory that “all bonds are bad” in the face of rising interest rates. Opportunities and trends will always present themselves. You need to have a keen income strategy to detect these trends, then capitalize on them when the timing is right.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. Click here to download their latest special report, The Strategic Approach to Income Investing.