What bond and bond fund investors need to know now

Jim Bernard, Senior Vice President, Ancora Advisors LLC

The outlook for traditional bonds and bond funds doesn’t look great with historically low yields today, and perhaps even lower yields and values on the horizon.

“Our concern today is that people are putting a lot of money into traditional bond funds, seeing the income that these bond funds produce,” says Jim Bernard, CFA, senior vice president and director of fixed income portfolio management, as well as an investment advisor representative at Ancora Advisors LLC.

However, that income is already falling and Bernard says it is going to continue to drop significantly.

“On top of that, the net asset values of these funds will be falling as the bonds they hold move closer to maturity because values today, in many cases, are significantly higher than the face value at which the bonds will pay off,” he says.

Smart Business spoke with Bernard about how the bond market works and what that means for investors’ portfolios.

How does the traditional bond market work?

Bonds are continuously traded based on two things: the risk of the investment and the current interest rate environment.  Currently, the likelihood of credit defaults is low for both corporate and government bonds. However, if a company has a history of losing money, you will want to pay a lower price for that bond or demand a higher interest rate in order to offset the risk of not getting your money back at maturity.

Interest rates and bond prices have an inverse relationship — as interest rates go down, bond prices go up. If you own a bond that pays a stated interest rate of 5 percent, due in three years, it would currently be worth more than face value to an investor because bonds maturing in three years are currently only paying 2 percent.

What do low interest rates and falling bond yields mean for investors?

Interest rates are low and have been for almost five years. They will likely stay this way for another two to five years. So the challenge is deciding whether investors should buy bonds that pay low rates of interest or put money in other places — the stock market, commodities, gold, real estate, etc.

If you bought a 15-year bond 10 years ago when interest rates were 5 percent or more, you might be happy. Unfortunately, most people tend to invest in bonds maturing within five years or sooner, and that means their bond holdings are at historically low yields.

What is the difference between owning an individual bond and a bond fund?

With individual bonds, you get the face value of your bonds back at the maturity date or call date, barring a default. In a bond fund, because it is perpetual, you never know what the future value will be.

Most investment advisers would prefer people invest in individual bonds if they have enough money to adequately diversify simply because of the added comfort of knowing what your bonds will be worth at maturity.

If you do not have enough capital to adequately diversify, or are in an instrument such as a 401(k), where individual bonds are unavailable, you may have to invest in bond funds if you want fixed-income exposure. You then must decide whether you are more concerned about the value of your fund or the income it produces.

What can we expect from bond funds in the future, and what should investors in bond funds do now?

Most individuals invest in bond funds in order to receive income, but that income has dropped dramatically as interest rates have fallen. For instance, one intermediate-term corporate bond fund has paid an average dividend yield of 5.4 percent over the past 12 months, but the current yield has already dropped to 3.3 percent. With five-year government bonds currently yielding 0.63 percent, is it not likely that the current 3.3 percent yield will be maintained.

The second reason an investor would buy a bond fund is for the net asset value of the fund. The net asset value of a bond fund typically only goes up when interest rates go down, but can interest rates go much lower, and therefore can bond prices go much higher? And even if interest rates stay flat, the net asset value will decrease as bonds within the bond fund get closer to maturity since the majority of bond prices are currently above face value.

So in general, concerning traditional bonds and bond funds, this is not a great time to be in either. If you have owned bonds or a bond fund for many years, you may be comfortable. However, for new money or money from maturing or called bonds, there are other, more attractive sectors with bond-like returns that are not as tied to interest rates. These include:

• Master limited partnerships, which pay a rate of interest through the infrastructure of the U.S. energy system, pipelines, etc.

• Certain real estate investment trusts, where income is derived from real estate projects.

• Certain sovereign bonds, which are non-U.S. government bonds and offer a way to diversify from the U.S. dollar.

• Merger arbitrage funds, which have bond return characteristics but are invested in equities.

If your bonds are still paying a good rate of interest, there is no need to be too concerned about selling as long as you are confident you are going to get your money back at maturity. However, right now may not be a good time to allocate new investments to the bond market.

Jim Bernard, CFA, is senior vice president and director of fixed income portfolio management as well as an investment advisor representative at Ancora Advisors LLC, an SEC-registered investment adviser. He is also a registered representative and a registered principal at Ancora Securities, Inc., member FINRA/SIPC. Reach him at (216) 593-5063 or [email protected]

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Board to post ‘accurate, real-time’ U.S. municipal ratings

WASHINGTON ― Real-time disclosure of the credit ratings on debt in the $3.7 trillion U.S. municipal bond market will be available in coming months, the board that collects market data said on Monday.

But the ratings will initially come from only one agency.

“We expect that will launch before the end of this year and will be a great furtherance of our mission to provide critical information to investors,” Municipal Securities Rulemaking Chairman Alan Polsky said in a call with reporters.

Along with writing the rules for the market, the board collects and posts disclosures and trading information for free on its website known as EMMA.

A little more than a year ago, the board announced that it would also make credit rating agencies’ assessments available on the site. At the time, it had hoped for all three rating agencies, or Nationally Recognized Statistical Rating Organizations, to participate. But only one, Fitch Ratings, has confirmed involvement.

“We will launch with one rating agency, possibly two, and we have received inquiries from actually other NRSROs,” MSRB Executive Director Lynnette Kelly Hotchkiss told the call. “They’ll go into the normal development cycle, so it’ll be a year or another amount of time before the second phase of that projects gets launched.”

There are two other major rating agencies beside Fitch — Standard & Poor’s Ratings Services and Moody’s Investors Service.

The board’s technology staff has labored all year to devise the best method for posting ratings immediately, Polsky said.

“The ratings need to be updated, available, accurate, real-time,” he said. “There’s a fair amount of testing that goes on to make certain that that process has the integrity, has what we need in order to be of the best use to investors.”

The board, made up of bankers, broker-dealers, advisers and issuers, has become a more centralized force in the municipal bond market. It is seeking to post large amounts of information about the debt that cities, counties, states and authorities use to finance their capital works as the federal government expands its responsibilities.

The financial reform law passed last summer, known as Dodd-Frank for its congressional authors, put municipal advisers under the board’s realm of rulemaking. Since then, the market has wrestled with exactly who can be considered an adviser. The Securities and Exchange Commission, which enforces the rules the board writes, is formulating a definition.

“Specifically, because of the market expertise of the MSRB board, we’re putting together a list of traditional activities of municipal advisers and we’ll be sending that to the SEC early this week,” Hotchkiss said. “The thinking is that that will help the SEC as they look at professionals in this market and whether or not they are providing what are traditional municipal adviser activities.”