ByDAREN FONDAELIZABETH O'BRIEN
Editor s note: As the market s woes drag on into 2009, investors are looking for something anything to serve as an alternative to stocks. In this special report, SmartMoney examines three of those alternatives bond funds, cash accounts and gold to see where the opportunities and the pitfalls lie.
Investors have been trained to think of stocks as the way to get big returns. But a growing group suggest that investing-thrill seekers should look at, of all things, bonds. Some bonds are priced so low (and sporting yields so high), it s as if investors expect the company or state agency that issued them to go bankrupt this year an unlikely prospect. Throw in the fact that bonds tend to outperform stocks during recessions and investors might have the chance to race away with profits without taking a huge amount of risk.
To be sure, some types of bonds have already picked up steam, and not all areas of the market look cheap. Last fall investors flocked to Treasury bonds, the debt issued and guaranteed by Uncle Sam, because regardless of how bad the economy gets, the Feds can always print more money to pay off the bonds. In all, they bought about $1.5 trillion of these types of bonds, driving up the price and creating unattractive yields. Indeed, the price of long-term government bonds jumped nearly 34 percent last year, which has essentially shut out investors from many of the deals.
But some investment pros contend that other bond breeds ones issued by companies or state and local governments are still bargains. Big, stable firms like IBM and PepsiCo recently issued 10-year bonds paying more than 7.5 percent more than two percentage points higher than the rates they offered on similar debt issued not even a year earlier. Analysts say even high-yield bonds (often called junk bonds) are attractive, even after some recent gains. Some of these things are trading as if the world is going to end, says Keith Berlin, vice president of fixed income with the Fund Evaluation Group, an institutional asset manager in Cincinnati. Municipal bonds the debt cities and states issue to cover the cost of building roads, sewers, hospitals and other projects also look promising. These types of bonds normally offer lower yields than a corresponding Treasury bond, because an investor usually doesn t have to pay taxes on interest from a municipal bond. But right now munis as a group are offering much higher yields.
Naturally, bonds still have drawbacks. If the recession considerably worsens, healthy companies and municipalities could run into financial trouble, hindering their abilities to pay off debts and likely depressing bond prices even further. Bonds could also underperform if the economy recovers quickly, which could send investors racing to the stock market. Bonds won t be exciting if stocks stage a big rally, says Don Whalen, a financial planner in Alpharetta, Ga., who still advises clients to keep a balanced portfolio of stocks and bonds.
Nevertheless, bonds could still provide better returns with less risk than stocks in 2009. With investors already showing a renewed interest in higher-yielding bonds, experts say one way to go is bond funds, which tend to be less volatile than owning individual bonds. For our picks, we looked for funds specializing in five areas of the bond world that have the best prospects. The five we selected all have solid long-term records and reasonable expenses. They should be reliable earners for these rocky times.
Osterweis Strategic Income (OSTIX)
Yield: 6.2%
Assets: $224 million
5-year Average Annual return: 3.2%
Comment: Designed to weather all market cycles, the fund recently has been adding short-term corporate debt.
Osterweis Strategic Income rocketed out of the gate in 2003, gaining 16.6 percent four times the bond market s returns that year and since then it s beaten 98 percent of other multisector funds, with annualized gains of 3.4 percent. The fund s manager, Carl Kaufman, holds a wide range of bonds, from corporate debt to busted convertibles, bonds that, had they met certain conditions, would have been transformed into stock. Certain types of bonds fare better in different credit and interest-rate cycles, he says, and he adjusts the mix based on his view of which types have the most upside and least risk. Lately, he s found attractive yields on short-term debt issued by companies such as Home Depot and Xerox. He generally sticks with firms that have strong cash flow and ample money to pay off their debts. Last fall he bought software maker Novell, which had $1.1 billion in cash and securities on hand 10 times the amount needed to cover its debts.
Since the fund holds only about 50 bonds, it can take a significant hit if only a few investments go awry. The fund was down 5.5 percent last year because Kaufman says he was too quick to invest in high-yield bonds. And the ongoing credit crisis has made it difficult for many corporate bond fund managers to buy corporate debt at the lowest prices. If the credit crunch persists, it could potentially dampen future returns. Still, Kaufman s style has paid off over the long term. The companies he invests in don t have to beat Wall Street earnings projections or even post a quarterly profit, he says. We just have to get the general direction right.
T. Rowe Price Tax-Free Income (PRTAX)
Yield: 4.8%
Assets: $1.7 billion
5-year Average Annual return: 2.0%
Comment: The managers combine shoe-leather site visits with bond analysis to outperform rival funds.
When he was deciding whether to invest in the bonds of a retirement community last year, Konstantine Mallas didn t just look at the community s balance sheet and bond price. Mallas donned a hard hat and toured the community s construction site in Rockville, Md. He talked to the site s foreman to make sure the project was on schedule and, most important, on budget. The shoe-leather approach helps Mallas decide which municipal bonds to buy for the T. Rowe Price Tax-Free Income fund that he comanages with Mary Miller. The fund invests in bonds issued by states and localities to build big projects, such as highways and high schools.
The fund s research-intensive focus has paid off. Mallas s fund has outperformed Morningstar s national municipal bond fund category every year for the past five years. Last year s 5.8 percent decline was still 3.6 percentage points higher than the average rival fund s. Muni bonds, as a group, were hammered last year, as some investors worried that the recession would hurt the ability of some states and towns to cover their debts (unlike the federal government, local governments can t print more money). But that sell-off has pushed the yields on many muni bonds to all-time highs. The yields on some 30-year muni bonds are now 24 percent higher than comparable 30-year Treasury bonds. Yields on munis normally are 10 to 15 percent lower than a comparable Treasury. Mallas s fund currently yields 4.8 percent, and considering munis tax-favored treatment, that equates to an effective 7.5 percent after-tax yield for people in the highest tax bracket.
Most of the fund s bonds are high-quality securities, rated AA, on average. In today s tough economy, Mallas particularly likes revenue bonds issued to fund essential services, like water and sewer systems. He recently added bonds issued by the water company in DeKalb County, Ga., and New York s Long Island Power Authority. Through the new economic stimulus plan, states will be getting money and that could lead to a rally in munis, which would push prices higher and yields lower. Even so, Mallas expects munis yields to remain relatively compelling for a while. It will certainly keep him busy in a market often stereotyped as sleepy. There s something different about every credit, he says. You can t rest on your laurels.
Janus High-Yield (JAHYX)
Expense Ratio: 0.9%
Yield: 11.5%
Assets: $392 million
5-year Average Annual return: -0.1%
Comment: Junk bonds form the core of this fund s holdings, although it avoids the highest yielding (and riskiest) debts.
After last year, investors might cringe at the mere mention of high-yield bonds, the debt from companies that are considered to be in some sort of financial distress. As a group, high-yield bonds were down 26 percent in 2008, the worst performance of any bond class. But now junk bonds yield, on average, almost 20 percent, and many pros think that type of potential makes the group attractive. For investors who can handle the risk, Janus High-Yield might be a good choice.
Run by Gibson Smith and Darrell Watters, the fund mainly holds bonds with a B rating or above. Those are still high-yield bonds, but they aren t the highest-yielding, riskiest loans. The fund has beaten 92 percent of other high-yield funds over the past five years, but it s not coasting on past performance. Janus recently added more bond analysts and new computer-modeling systems to better manage risk. We don t want to put our shareholders in harm s way, says Smith, who also oversees Janus s fixed-income team.
One tactic that s working: sticking with asset-rich firms. For example, Smith and Watters built a stake in Dole, the fruit company that has been stymied by higher tariffs in Europe. If things get worse, the company s land holdings in Hawaii could be sold to repay bondholders. In this kind of market, you want downside protection, says Smith.
Granted, investors might still be in for a roller-coaster ride. Analysts expect the default rate on corporate bonds, now at nearly 4 percent, to accelerate considerably. Historically, returns for high-yield bonds have been very low when defaults have crept up, says Martin Fridson, a high-yield investing veteran and head of Fridson Investment Advisors. And a big collapse of one high-yield company like General Motors could trigger another group sell-off.
For his part, Smith acknowledges that a lot of companies won t survive the credit crunch. But the fund has been durable, beating its benchmark index in the last two bad debt markets. The fund s 11.5 percent yield offers a buffer against another downturn in the market. By nature I m risk-averse, says Gibson, who likes to ski in his leisure time, though never off-trail. That cautious approach just might be exactly what an investor wants in a high-yield manager.
Templeton Global Bond (TEGBX)
Yield: 8.3%
Assets: $11.1 billion
5-year Average Annual return: 6.0%
Comment: The fund invests heavily in foreign country debt. It also aims to profit off interest-rate swings.
Hanging out with government officials isn t unusual for Michael Hasenstab, 35, the manager of the Templeton Global Bond fund. He can often be found in capitals from Malaysia to Mexico, talking interest rates and currencies with the country s top bankers and finance ministers. Racking up the frequent-flier miles appears to have helped. Since he took over the fund in 2001, it has beaten 96 percent of other world bond funds, with a 10.5 percent annualized return. Even last year, when most rival funds lost money, it gained 5.8 percent. Last year was the best stress test we could have imagined, Hasenstab says.
Hasenstab mainly holds government bonds, including sizable stakes in the debt of emerging nations. But he will move into currencies or sovereign debt (bonds issued in a foreign currency). In 2008 his moves included a bet against the euro, which paid off handsomely in the second half of the year, and buying government bonds from New Zealand and Korea. It s an eclectic approach, he says, that allows us to minimize risks of any individual countries.
That may be true, but some of his moves may give investors pause. He bought Iraqi sovereign debt a couple of years ago, at the height of the country s civil strife, and he currently holds long-term Russian bonds, denominated in dollars. We think the probability of default by Russia is fairly low, he says. And the Iraqi debt was profitable, he adds. Still, other funds with less exposure to emerging markets may not be as risky, notes Morningstar analyst Eric Jacobson. And getting all the currency moves right, Jacobson says, can be tricky.
For his part, Hasenstab argues that his ability to bet against currencies and interest rates helps him profit off different stages in foreign business cycles. But he does admit to one downside in his style. There s no magic pill for the jet lag, he says.
Dodge & Cox Income (DODIX)
Yield: 5.7%
Assets: $13.8 billion
5-year Average Annual return: 2.2%
Comment: A bread-and-butter bond fund, it invests in high-quality corporate bonds and government-backed mortgage securities.
Dodge & Cox likes to keep things simple in its eponymous bond fund. Run by an investment committee, the fund doesn t use derivatives or leverage and mostly sticks with the meat and potatoes of the bond world: high-quality corporate debt, government-backed mortgage securities and a smattering of Treasurys thrown in the mix. We believe in building yield into the portfolio, says Dana Emery, a Stanford graduate and committee member who helped start the fund in 1989. But we try to do it in a careful way.
Caution is a big buzzword in the bond world. But at Dodge & Cox, prudence really seems to be ingrained in the culture and it pays off for shareholders. If a bond makes it into the fund, the team aims to hold it at least three years, even if it takes a short-term dip. Going back to the late 90s, the fund has gained an average of 5.1 percent a year. Those aren t eye-popping returns. But as an intermediate-term bond fund, it isn t designed to shoot the lights out, and it has beaten 86 percent of other funds in its category over the past decade. They take a long-term view, says Morningstar analyst Dan Culloton. And they re very consistent.
The fund has long been a fan of the cable business and added to its positions last year, when yields on some cable-company bonds rose near 9 percent. With millions of customers and monthly income streams, the cable companies should have no trouble paying their debts, says Emery. She likes railroad bonds for similar reasons. They re basically oligopolies, she says of companies like CSX and Union Pacific. And the bonds in the fund are backed by collateral such as multimillion-dollar locomotives.
If there s a downside to this approach, it s that the managers don t like to trade much. Annual turnover is only 24 percent, which keeps expenses down, but it hurt in last year s fast-moving market, when corporate bonds sold off and investors flocked to Treasurys. The fund lost just under 1 percent, while its benchmark index gained 5.2 percent. Not having enough exposure to Treasurys hurt us, Emery says, blaming the underperformance on dysfunction in the bond market. Assuming things return to normal, though, the fund should get back to its winning ways.
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