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Zen and the Art of Bond Maintenance
By Stephen J. Butler |
 Archives |
For many people
new to the investment experience, the world of bonds (or bond
mutual funds) is a mysterious "black box" housing a
mechanism that involves too many moving parts. I'm reminded of
the book "Zen and the Art of Motorcycle Maintenance"
whose obsessive-compulsive author illustrated how satisfying it
could be to understand how a piece of machinery actually worked.
It was not enough to get from to point "A" to point
"B." You were missing something vital in life if you
failed to understand the workings of your source of transportation.
We can gain a faster understanding of bonds by looking first at
the extremes. Anyone who has invested in a High Yield Bond fund
three years ago has watched their capital drop in value by about
20% over that period of time. However, they should force themselves
to avoid peeking at their fund's Net Asset Value (the mutual fund
share price or NAV) and just enjoy spending the dividend. They
have received one of the best and most predictable incomes of
any investment available over that period -- between 8 and 9 percent.
While the capital value may have dropped, the income stream has
remained constant.
To some, it may feel like they are "dipping into their principal;"
a practice that the rich are always warning themselves against.
However, the NAV is usually just a temporary victim of the sentiments
in the bond market. Sooner or later, a well-run bond fund "reverts
to the norm" which means that the greater proportion of the
bonds retain, on the average, their original value. When this
happens, our mutual fund's NAV should return to its original value
and should represent about a twenty percent rise in NAV. In the
meantime, those dividends have been ours to keep. The real winners
will have been those who didn't spend their dividends. Instead,
they had that income automatically reinvested and effectively
dollar-cost-averaged their way through the period of those lower
NAV's.
To best understand what high yield bonds can accomplish, we can
look at two popular bond funds as well as a single high-yield
bond by itself. Vanguard High-yield Corporate and Pimco High Yield
are two bond funds that are considered to be at the conservative
end of the high yield spectrum. Vanguard's fund is managed by
Wellington Management and has a major advantage in the extremely
low annual cost of only .27%. Pimco, by comparison, is more expensive
at 0.90% plus a sales commission, but the fund company is one
of our premier bond managers.
To understand the interior workings of one of these bond funds,
we should also look at a single bond of, say, Tyco International.
Here is a company whose bonds have been recently downgraded because
of some bad publicity, but the company is actually larger than
General Motors and Ford combined. It generates a huge amount of
cash and it is consistently profitable. The controversy is centered
around how fast, exactly, the company is growing. Thanks to this
controversy, its existing bonds scheduled to mature in 2006 have
dropped in value. This has made the 6.38% coupon (the bond's interest
payment) suddenly equivalent to an 8% annual yield for someone
who buys the bond today at its current discounted cost of $960.
In theory, some unpredictable doomsday situation could cause Tyco
to actually default on the bonds and not pay all of the principal
back. I say "unpredictable" because the bond market
only discounted the bonds down to $945. Some would call this a
vote of confidence on the part of professional bond traders in
the wake of media hysteria that drove the stock down to half of
its previous value. Meanwhile, today's buyer of the Tyco bond
will enjoy an 8% return until 2006 and they will also benefit
from the "bump" in capital value as the bond rises from
its current lower price of $960 back to its original $1,000 value.
(The yield calculation for the Tyco bond INCLUDES the expected
rise in capital value between now and maturity.)
This description of Tyco's bond helps to explain what is happening
in a High Yield Bond fund that buys millions of similar bonds.
In general, recent economic conditions have impacted all high
yield bonds generating results similar to what we see in the Tyco
case. In some situations, the fund will actually sell a bond at
a loss because they want to avoid what they sense is an impending
default. In other cases, these funds actually lose money when
customers cashing in their shares force fund managers to sell
bonds that have dropped in value before they have had a chance
to recover.
Some high-yield bond funds, like Pimco's and Vanguard's, have
a reputation for having very few, if any, defaults. This means
that the bonds they buy generally have the potential to sidestep
capital ultimate losses. When bond markets are hot, these funds
do not do as well as some of the more aggressive high yield bond
funds that take on more risk. In economic climates like we have
had over the past year, however, a conservative fund with no defaults
will offer less "downdraft" of capital value than a
more aggressive fund that has been fighting for higher yields.
Those who are searching for higher rates of return would do well
to experiment with conservative high yield bond funds and become
comfortable with what, for most, is an admittedly uncomfortable
concept. If Warren Buffet is right in his assessment of stock
market returns averaging 7% per year for the next ten years, investing
some money in bonds may not involve much in the way of opportunity
costs (the "lost opportunity" of what money could have
earned in the market.) In addition to their regular income, high-yield
corporate bonds may offer the promise of an overdue "bump"
in capital gains from their current, depressed values.
BUYandHOLD
does not offer or provide any investment advice or opinion regarding
the nature, potential, value, suitability or profitability of
any particular security, portfolio of securities, transaction
or investment strategy. Any investment decisions you make will
be based solely on your evaluation of your financial circumstances,
investment objectives, risk tolerance, and liquidity needs. The
securities mentioned above are being used for illustrative purposes
only and should not be regarded as an offer to sell or as a solicitation
of an offer to buy. Mutual funds may differ from equity securities
in investment objectives, liquidity and diversification, and tax
consequence. Please check with your accountant regarding your
specific tax consequences. The securities markets are subject
to the risks of fluctuating prices and the uncertainty of rates
of return and yields inherent in investing and past performance
is no guarantee of future results. Bonds offer a fixed rate of
return if held to maturity.
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