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Bond Funds for the Long Term by James D. Peterson, Ph.D., Vice President, Investment Manager Research, Schwab Center for Financial Research and Justin Holt, CFA, Senior Research Analyst, Schwab Center for Financial Research Updated October 28, 2008 Updated from the October 2008 issue of Schwab Investing Insights®, a monthly publication for Schwab clients. Recent economic and market turmoil has sent investors big and small seeking safe places to invest their money. But when even a few money market funds "broke the buck" last month, it seemed that there was hardly any safe haven left in which to invest cash. So, investors rushed into U.S. Treasury securities. However, if you compare current Treasury yields with inflation (as measured by the Consumer Price Index [CPI]), you'll see in the table below that their real yields are actually negative. As Treasury yields have fallen, yields on high-quality corporate and asset-backed securities have risen to, or near, all-time highs, so there's no need to step too far out on the risk spectrum in search of yield.  Meanwhile, the prices of bonds in sectors other than Treasuries have plummeted, battering many bond funds. But if you're looking to hold for the long term, the current crisis may actually present opportunities to invest in certain well-positioned bond funds at what could turn out to be bargain prices—if you can stomach some short-term volatility. In search of a catalyst The markets have been under fire since July 2007, as the crumbling of the U.S. housing market spread into the biggest liquidity crisis in nearly 80 years. Banks have been tightening lending standards dramatically while U.S. corporate commercial paper issuance—the lifeline for many business operations—has fallen considerably. The good news is that the government is very eager to try to avoid a market meltdown and is taking unprecedented action to combat the problems. The Federal Reserve has attempted to soothe investors by coordinating a global central banking effort to prop up ailing money markets by injecting hundreds of billions of dollars into the system. Most ambitiously of all, Congress recently passed the much-debated $700 billion Emergency Economic Stabilization Act, giving the Treasury the power to take over distressed mortgage assets from financial institutions. Taken together, we believe these government moves could set the stage for an eventual turnaround in high-quality, investment-grade bonds. Here are three funds we think are well positioned for such a shift: PIMCO Total Return Bond Fund (PTTDX) manager Bill Gross sees compelling yield and capital appreciation potential from its core positions in short-term, U.S. mortgage-backed securities. At almost 70% of the portfolio, these issues, amongst the most liquid and low risk bond sectors around, are widely held by foreign governments and currently hold an advantage in yield over Treasuries. However, despite receiving explicit support from the U.S. Treasury pursuant to its establishment of a conservatorship for Fannie Mae and Freddie Mac, the securities of these issuers are considered riskier than Treasuries due to their susceptibility to higher price volatility and lower market liquidity, in addition to other factors.1 With a nearly 20% weight in corporate bondsincluding long-dated investment-grade corporates, which have lagged riskier higher-yield issues so far in 2008—PIMCO is seeing what they believe to be some unusually strong valuations and opportunity in these lower-risk bond segments. Metropolitan West Total Return Bond Fund (MWTRX)—like PIMCO Total Return—sees outstanding value in the mortgage-backed bond sector, where the fund holds approximately 60% of its assets. However, in marked contrast to PIMCO, MWTRX has shown a greater willingness to dabble in nongovernment-issued mortgage-backed bonds (approximately 5% of the fund). These securities sport a higher yield than those issued by Fannie and Freddie, due to their lack of government backing. To offset this inherent risk, Met West only invests in senior tranche issues—the most heavily collateralized issues available in a given loan pool—which helps ensure that they generally have first dibs on principal repayment. Federated Total Return Bond Fund (FTRFX) may appeal to investors seeking a high-quality bond fund with broad diversification across all sectors represented in the Lehman Brothers Aggregate Bond Index (a broad-based index that's often used to represent U.S.-traded investment-grade bonds). The fund tries to identify areas of the market offering better long-term return based on yield and price interrelations between the various bond sectors. We believe the fund's multicommittee management structure and strict risk management create a solid strategy for adding value. Consider harvesting your losses If you do own a fund that's experienced a capital loss and you're not sure if you want to hold it for the long term, you may want to consider selling it this year to realize the loss and offset gains elsewhere in your portfolio. Currently, the IRS allows for up to a $3,000 net capital loss write-off, which can be deducted from reportable income. For more detailed tax-loss advice, see Get a Tax Break by Harvesting Losses. Important Disclosures Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. The current and future portfolio holdings contained in a mutual fund is subject to risk you should be aware of prior to making an investment decision. Past performance is no guarantee of future results, and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost. See Schwab.com for more recent performance. 1. Government Sponsored Enterprises (GSEs) issue securities to support the origination of mortgages for American home buyers, as in the case of U.S. mortgage-backed securities. U.S. mortgage-backed securities (MBS), when compared to Treasuries, carry additional risks including greater fluctuation of principal investment, generally higher transaction cost, prepayment and extension risks, and other factors. The U.S. Treasury Temporary Guarantee Program provides a guarantee to participating money market mutual fund shareholders based on the number of shares invested in the fund at the close of business on September 19, 2008. Any increase in shares in the account after the close of business on September 19, 2008, will not be guaranteed. If the value of these shares fluctuate over the period, investors will be covered for either the number of shares held as of the close of business on September 19, 2008, or the current amount, whichever is less. The Program expires on December 18, 2008, unless extended by the U.S. Treasury. A bond fund’s Net Asset Value will fluctuate with the price of the underlying bonds and portfolio turnover activity. Return of principal is not guaranteed. Bond fund shares are subject to increased loss of principal during periods of increasing interest rates. Approximately 2,100 funds participate in the Mutual Fund OneSource® service. Only these funds, including Schwab Affiliate Funds, are eligible for the Mutual Fund OneSource Select List. Schwab receives remuneration from fund companies, and/or their affiliates, in the Mutual Fund OneSource service for recordkeeping, shareholder services and other administrative services. This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. (1008-8903) Return to Top |
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