The Trouble Ahead

This article published with permission from InvestmentU.com.

Warren Buffett recently opined that bonds should come with a warning label these days.

That is doubly true of most bond funds. Many investors are about to get steamrolled. But if you act now, you can avoid getting hurt.

Let me explain…

Historically, the best-performing bond funds have had one thing in common: low expenses.

For example, Vanguard’s fixed-income funds are routinely found in the top quartile of annual bond fund performance. Why? Unlike stocks — where security selection is the key to outperformance — it’s tough to increase returns by picking individual bonds.

However, I’ll concede that it is possible.

More than 30 years ago, Bill Gross and his colleagues at PIMCO pioneered a new approach to bond investing. Until then, a lender handed his money over to the borrower and then collected interest until the borrower repaid the loan.

The notion that anyone might routinely trade these instruments by selling them to others prior to maturity did not exist.

Gross recognized that opportunities exist to trade in and out of various sectors of the bond market — as well as individual issues — and moved to capitalize on this reality.

As a result of his expertise, the PIMCO Total Return Fund has outperformed through all market cycles over the long term. But Gross is often called “The Babe Ruth of Bonds” precisely because this is so darn hard to do.

Historically, the vast majority of fixed-income managers underperformed their unmanaged benchmark, like the J.P. Morgan Global Government Bond Index or the Barclays Capital Aggregate Bond Index.

But — surprising many analysts — this hasn’t been the case lately.

Hitting the Mark

Last year, for instance, 79% of intermediate-term bond funds — which hold a mix of government and corporate bonds maturing in five to 10 years — beat their benchmark. And over the past year, investment-research firm Morningstar estimates that long-term government bond funds beat their benchmarks by 2.5 points.

Wow.

Predictably, money is now cascading into actively managed bond funds as investors chase performance the ways dogs chase cars. (And with the same general results.)

Industry figures show that three-quarters of new fixed-income investments are going to bond pickers, not passively managed index funds.

Big mistake.

The hot bond funds are hot precisely because they are taking significantly more risk than the index funds.

Consider “duration,” a measure of a fund’s sensitivity to interest-rate changes based on the average maturity of the bonds it holds. As most bond investors know, you get a higher yield by owning longer maturities. So these bond fund managers have simply increased the average duration of the bonds in their portfolios.

This is all well and good as long as rates are steady or dropping, as they have been for the last 30 years. But when rates rise — as they inevitably will as the economy improves and the Federal Reserve ends its quantitative easing policy — these bonds (and bond funds) will get hurt much more than those with shorter maturities.

Dumb moves

Bond managers also goose returns by buying “junkier” bonds. This, of course, is riskier than owning bonds of higher credit quality.

And, thirdly, many bond managers are using leverage. That means they borrow money to buy extra bonds and thereby further increase yields. This is the equivalent of buying stocks on margin — and shareholders can expect the same result when the bond market sells off (which it will when interest rates rise).

In short, at the tail end of a 30-year rally in bonds — the longest and most massive in history — investors are piling into precisely the wrong investment. They are buying actively managed funds (with high expenses) that own longer maturities and riskier credits using leverage.

If you don’t understand what is going to happen here, visit your local old-timer and ask him what happened to his fixed-income portfolio in the early ’80s.

It wasn’t pretty.

And while it’s unlikely we’ll see the sort of hyperinflation that plagued investors three decades ago, bond fund buyers are in for a rude awakening when they see what happens to their supposedly “safe” fixed-income investments in a rising interest rate environment.

All fixed-income investors face an important choice. They can switch to low-cost, passively managed short-term bond ETFs and index funds, or they can stick with the active fund managers and learn the hard way.

The wise will opt for the former. As Ben Franklin said, “Experience is a dear school but fools will learn in no other.”

Alexander Green is the chief investment strategist at InvestmentU.com. See more articles by Alexander here.