Escalating sovereign debt problems in
Europe plus the recent weak U.S. employment reports have raised fears
that we could be headed into recession again.
Should that scenario play out, stocks are
likely to head down, but bondholders will probably still make money.
However, individual bonds are not as easily traded as stocks so it
makes more sense for individual investors to buy funds that invest in
bonds rather than the bonds themselves.
If you believe that the economy is headed
down, or if you simply want to hedge your bets, here are four funds
that, in my view, would be suitable. Two are exchange-traded-funds
(ETFs) and two are closed-end-funds.
ETFs are funds that generally track
preset indexes while closed-end funds are actively managed. They are
called “closed-end” because they only sell shares when they first go
public. After that, the shares trade on the open market just like
When selecting bond funds, you have to consider risk; specifically
historical volatility and the future risk that the bonds held by a
fund might default.
The best historical volatility gauge has a scary name: “standard
deviation.” Despite the name, the concept is simple. Standard
deviation measures how much a fund’s share has price bounced around in
the past, regardless of whether in the end, it moved up, down, or
sideways. That’s important if for no other reason than it’s
those nasty price swings that keeps you up nights, and incite
you to bail out just when the fund has touched bottom.
Bond fund standard deviations generally range between 4 and 20. The
higher the standard deviation, the higher the risk. You can find the
standard deviation for any fund on Morningstar (www.morningstar.com)
Ratings & Risk
Although, far from perfect, bond credit ratings from agencies such as
Standard & Poor’s and Moody’s are the best tools we have for
evaluating the changes that a company might sometime in the future
default on its bond payments. Bond raters use a
combination of letters, numbers, and plus or minus signs to express
their ratings. The specific format varies between ratings services but
“AAA” always indicates the highest quality rating, and any rating
starting with “A” signifies reasonably high quality debt. Three letter
ratings starting with “B” such as BAA or BBB indicate lower quality
debt than “A” ratings, but are still considered investment quality.
One or two letter “B” ratings and anything starting with a “C” is
considered below investment quality. Thus, for this strategy, funds
with significant holdings should be avoided.
You can use Morningstar’s
Report to see the percentage
of bonds corresponding to each rating held by a fund. Taking all that
into account, here are my four bond fund suggestions, listed in order
of increasing risk. All
pay monthly dividends.
Vanguard Total Bond Market
Vanguard, an ETF, tracks an index that represents a wide variety of
medium-term government, government percent on average annually with a
4.3 standard deviation. Its 3.2% estimated annual dividend yield (next
12-month’s dividends divided by share price) won’t knock your socks
off, but it beats what banks are paying. Considering the low
volatility, solid credit ratings, and diversity of its holdings,
Vanguard Total Bond is about as close as you can get to a bank account
replacement. However, unlike bank accounts, it’s not insured by the
AllianceBernstein is a closed-end fund. About 65% of its assets are
invested in securities issued by the U.S. government or its agencies.
AB invests the balance in U.S. corporate and foreign government debt
securities. As of August 31, 71% of its assets were AAA rated debt. AB
Income has returned 6% on average, annually, over the past three years
with an 8.6 standard deviation. Its expected annual dividend yield is
iShares Investment Grade Corp.
The fund, an ETF, holds investment grade bonds issued by corporations,
mostly issued by U.S.-based corporations. Unlike AllianceBernstein
that focuses on AAA rated bonds, iShares holds mostly A and BBB rated
bonds, which are at the lower end of the investment grade range. Even
so, the standard deviation is a relatively low 10.7. The fund has
averaged a 6% return, on average, annually, over the past three years.
It pays a 4.6% expected dividend yield.
Hancock Premium Dividend
Hancock, a closed-end fund with a 20.8 standard deviation, is, on the
surface at least, the riskiest fund of the group. But, in this
instance, the standard deviation is misleading. Here’s why.
Hancock holds both common and preferred
stocks of U.S. companies, but preferred shares account for more than
60% of its portfolio. Preferred stocks are more like bonds than
stocks, which is why I’m recommending the fund.
As you may recall, in September 2008,
when it seemed like the economy was falling off a cliff, the U.S.
government took control of Fannie Mae and Freddie Mac, the two
corporations that guaranteed a big percentage of home mortgages.
Immediately after the takeover, the government forced Fannie and
Freddie to stop paying dividends on their preferred shares. News of
that event triggered a selloff in all preferreds, as much as 40% in
many cases. Hancock Premium’s standard deviation reflects that
selloff, even though most preferreds recovered within a few months.
Without that dip, Hancock’s standard deviation would probably be in
the 12 to 15 range. What makes the Hancock fund so appealing now is
that more than 50% of its holdings are utilities; one of the
industries that would be least affected by an economic downturn.
The Hancock fund as returned 24%, on
average, annually, over the past three years. Its expected dividend
yield is 7.2%.
Bond funds typically outperform stocks in
a weak market and underperform in a strong market. Because bond prices
move opposite to overall interest rates, you can lose money on bond
funds in a rising interest rate environment.