3 Places to Hide in the Bond Market

Jonnelle Marte
February 4, 2011

Investors have been bailing out of the bond market for months, in search of better yields and -- believe it or not -- safer investments. But to completely abandon fixed income would be a major mistake: Bonds are still one of the best ways to create steady income and diversify your portfolio, industry pros say. You just need to know where to look.

These days, investors have every reason to be wary of bonds: Interest rates will almost certainly rise, and worries have mounted about potential defaults by cash-strapped state and local governments. Investors have pulled nearly $23 billion out of bond funds, primarily muni funds, since December, according to the Investment Company Institute.

Of course, most bond fund managers downplay any talk of a "bond bubble." Because the bond market is less volatile than the stock market overall, they argue, losses from a collapse would not be as drastic as those stocks suffered during the financial crisis. Recall that during the last major bond market collapse in the late 1970s, long-term U.S. government bonds lost 20% of their value, while stocks dropped more than 50% in the most recent downturn and more than 80% during the Great Depression, according to Ibbotson Associates. Still, most fund managers with the flexibility to invest in a wide array of bonds are making moves now to protect themselves.

"The next move in rates is up," says Thomas Atteberry, portfolio manager of the First Pacific Advisers New Income Fund (Nasdaq: FPNIX - News). "We don't necessarily know when that will start, but I'd rather be early to the party [by moving into bonds less tied to rates] than late." Atteberry says he has limited his fund's exposure to interest rate risk by investing primarily in bonds that mature in 5 years or less.

In fact, when rates rise, some bonds hold up better than others. While Treasury bonds are basically considered free from credit risk, because the U.S. government is unlikely to default on its debt, their paltry yields and fixed rates make them particularly vulnerable to interest rate risk. Some fund managers have been scaling back their exposure to Treasurys and increasing their stakes in bonds with higher yields. This typically makes bond portfolios less sensitive to rate increases, but at a greater risk of defaulting. Other managers are re-evaluating their investments in troubled municipalities. Here are three places to hide in the bond market.

Commercial Mortgage-Backed Securities

After seizing up during the credit crisis, the CMBS market appears to be turning around, as investors seek higher yields than what's offered by government or corporate debt. Today, CMBS yield on average 2.2 percentage points more than Treasurys, and the securities themselves are "still relatively cheap," says Gregory Davis, who manages the Vanguard Total Bond Market Index Fund (Nasdaq: VBMFX - News). But that extra yield comes with greater risk: Investors could lose money if the owners of the underlying mortgages default. Davis says an attractive area is CMBS backed by properties like shopping malls, office buildings and warehouses. Davis's fund has returned an average 5.76% a year for the past five years, compared to the average 5.82% seen by its benchmark Barclays Capital U.S. Aggregate Bond index, according to Morningstar. The fund charges 0.22%, or $22 for each $10,000 invested.

High-Quality Corporate Bonds

Corporate bonds are generally less impacted by interest rate movements than Treasury bonds, says Tony Crescenzi, portfolio manager at Pimco. Historically, they're also more likely to default. But with the economy growing, and many companies reporting strong earnings, "the risks are not as great as they have been," he adds. Some sectors with strong corporate bonds include utilities, gas pipelines, gold miners and cable providers, says James Keegan, chief investment officer of Seix Investment Advisors and portfolio manager of the Ridgeworth Funds Total Return Bond Fund (Nasdaq: SAMFX - News). About 35% of Keegan's fund is invested in corporate bonds, and about 45% is in mortgage-backed securities. The fund posted an average annual gain of 6.39% over the past five years, outpacing the Barclays U.S. Aggregate Bond Index by 0.6 of a percentage point. It charges 0.35%, or $35 for every $10,000 invested.

Revenue Bonds

With many investors worried about a meltdown in the muni bond market, some fund managers say they've turned to municipal revenue bonds, those financed by the income from a particular project, such as an airport, school or hospital. Revenue bonds can be risky, because if the project or business doesn't make enough income, the issuer may default. But revenue bonds supported by essential services -- like those backed by water, sewer and electric companies -- have been doing well since the downturn, says Duane McAllister, who runs the Marshall Intermediate Tax Free Bond Fund (Nasdaq: MITFX - News) and has been increasing his exposure to revenue bonds since 2007. And if a city files for bankruptcy, revenue bonds aren't always part of the bankruptcy process, he adds. "You have to pay your electric bill, you have to pay your water bill," says McAllister. On the other hand, he avoids bonds backed by tobacco sales and those supported by apartment complexes, which have seen frequent foreclosures in some areas of Florida. His fund gained an average 4.64% annually over the past five years compared to an average annual return of 3.88% by the Barclays Capital Municipal Bond Index, and charges 0.55%, or $55 for every $10,000 invested.

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