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Dan Vrabac
Portfolio Manager
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Waddell & Reed Market Perspective - November 2011
Back in 1979, Douglas Adams published The Hitchhiker’s Guide to the Galaxy. The Guide of the book’s title was an electronic device (not unlike an iPad) which had access to all the information available in the universe. One of the story’s running themes was that the main characters would turn to the Guide when they got into trouble on their intergalactic journeys — which happened frequently in Adams’ humor and mayhem-filled science fiction parody of hitchhikers in Europe. Because the Guide was typically accessed in times of trouble, “Don’t Panic!” were the first words to flash on its screen when it was turned on.
This is an appropriate analogy for thinking about today’s bond market. Every time you turn on your computer and pull up your market screen or search for market news, the headlines and price moves are enough to jar the most steadfast of souls. Our advice: Don’t Panic! Here’s why.
Cognitive dissonance results when your brain is considering contradictory concepts simultaneously. Today, this is very true for investors who desire higher income on their investments, but at the same time are bombarded by media pronouncements that bond bubbles exist and that buying bonds at today’s low interest rates is a sure loser. Yet investors are scared of equities, as evidenced by over $400 billion withdrawn from equity mutual funds by retail investors since 2007 (according to the Investment Company Institute). Result: panic, or at least a modicum of anxiety. So, is there a way to overcome cognitive dissonance, reduce panic, and be comfortable investing in bonds?
Bond fund managers attempt to avoid most of the bubble risk by prudent asset and maturity selection.1 For example, consider the three primary ways that bond investors can get hurt — rapidly rising interest rates, rapid increases in inflation, and defaults. The first two can be mitigated by having a long investment horizon, by the maturity of the bonds owned, and by adding adjustable rate bonds into your portfolio. Default risk may be mitigated by the quality of the bonds you own, the seniority of those bonds, and also by careful use of derivatives.
Earning additional income in the current low interest rate environment means either investing in longer maturities, or taking a little more risk in the type of bonds you own (it is possible to do both, but let’s concentrate on investors who don’t want to take both risks at the same time). If you’re buying longer maturity bonds to get extra income, you are probably going to buy U.S. Treasuries or very high quality corporate or municipal bonds. However, in today’s market, those yields may not adequately compensate you for the first two risks mentioned above — rapidly rising interest rates and inflation. If one or both of those occur, long maturity bonds will suffer significant price declines. If you need your money, you’ll take a big capital hit when you sell. These are the type of bonds and bond funds the financial media talks about when it spreads fear about bond bubbles and claims that bonds today are expensive.
However, by only focusing on one area of the bond market, we think those pundits are missing very good opportunities in other sectors of the bond market. Specifically, we believe bond funds that invest primarily in medium and lower-grade corporate bonds with short to medium-term maturities may be just the thing for panicky investors suffering from cognitive dissonance. Corporate bonds yield more than government bonds, so you don’t need to take on excessive maturity risk to earn a decent income. A good mixture of high, medium and lower quality corporate bonds in your portfolio can help reduce both volatility and any potential adverse impact from defaulting bonds, though diversification cannot ensure a profit or protect against loss.
Furthermore, adding global bonds provides additional diversification and yield opportunities. The Waddell & Reed bond funds have decades of management experience in analyzing and selecting all of these types of corporate bonds for your portfolios.
Selecting bonds from companies that have survived numerous economic cycles, that have strong balance sheets and cash flows, or that have substantial tangible assets available to the bondholder in the case of default — this is how the Waddell & Reed bond fund managers mitigate the risk of owning corporate bonds versus government bonds. Traditionally, government bonds were seen as a safe haven. However, ultralow yields on short to intermediate bonds and inflation risk embedded in longer bonds means that investors may need to look beyond government bonds to achieve their desired income level. As an aside, one should recall that not even some government bonds are safe today — one need look no further than Europe to understand that.
Let’s take a look at how much extra yield is available in the corporate bond market versus the government bond market. As you can see in the chart above, you can earn a lot more income and keep a shorter maturity by investing in corporate bonds. Focus on the yellow vertical bar which highlights yields at the 5-year maturity range. Currently, the 5-year U.S. Treasury yield to investors is less than 1.0%. As an aside, according to Bankrate.com, 5-year jumbo certificates of deposit are paying around 1.25 percent (and your money is tied up for five years, and subject to penalties for early withdrawal). Now look at the corporate bonds. Investment grade BBB bonds at 5 years yield nearly 3.0% (red line); adding some U.S. dollar emerging market bonds of BB quality gets you over 5.0 percent (green line), and adding in some U.S. High Yield “B” bonds gets you up to over 6.50 percent (purple line). As you can see, blending corporate bond funds across different quality ranges and geographic sectors can improve your income potential, enhance your portfolio’s diversification, and help to mitigate downside risk from inflation and rising interest rates.
Risk Factors
Now, let’s discuss the risk involved when buying bond funds that consist primarily of corporate bonds. In the first place, there will always be volatility in a bond fund’s net asset value (NAV). Typically, the lower the credit quality or the longer the maturity the more volatile a fund’s NAV will be.
In times of stress, medium and lower grade bond prices may fall precipitously. Here are the primary reasons why this occurs:
- Wall Street traders don’t buy to hold, they buy to trade. In a sudden market downturn, they may be left holding bonds that suddenly no one wants, while they watch prices melt away. They will sell at lower prices just to remove the bonds from their inventory to avoid further losses.
- Some investment managers may experience cash outflows from their funds during periods of market stress. They may be forced to sell at any price in order to meet redemptions. Being forced to sell, they often — to use the old expression — “throw the baby out with the bathwater.” They end up selling their best bonds, because those are the only ones for which liquidity or demand exists in the market.
- During periods of market stress, markets can temporarily dry up — no one is willing to buy or sell bonds — so although there may be little trading volume, dealers duly mark down prices until sellers and buyers are brought together.
- Speculators (short-term traders), like Wall Street traders, sell to avoid further losses because they are only concerned with price moves, and not generating a long-term stream of income.
- Leveraged players (like hedge funds) receive margin calls on borrowed funds and are forced to sell their bonds to raise cash.
These stressful situations are a tremendous buying opportunity for those bond funds that keep liquidity on hand to take advantage of adverse market moves. Adroit managers will add to existing positions or start new positions when prices are depressed. Sure, in the interim, what’s already in the portfolio will be hit by market moves. This is the NAV volatility referred to above. But here’s the important thing to remember: bonds are not stocks. If a stock price falls, there is no guarantee it will ever come back up, or perhaps not come back enough to get your money back or earn a decent return. Bonds, however, are a contract — at the stated maturity, you get back your original principal. In the meantime, you collect interest. It doesn’t matter if you buy bonds at a premium to their par value — with bonds, your return is locked in at purchase — assuming you hold to maturity and no default takes place. Furthermore, once the period of stress passes, bonds can potentially move back to at or near their prior levels. Therefore, unless you are speculating on interest rate moves by buying long-duration bonds or bond funds, we think the best strategy for bond investors is to hold tight (or better, add to their holdings) at times of market stress.
Here are two examples of how bond prices performed in the recent market stress during August-September 2011. One is a U.S. high-yield bond, and the other a U.S. dollar denominated emerging market bond. It’s important to remember that these situations were not a result of a change in a company’s fundamentals — they primarily reflected a sudden loss of market liquidity and a panic by the motivated sellers described above.
Melco Crown Entertainment (MPEL) develops, owns and operates casino gaming and entertainment resort facilities. The bond in question is the 10.25 percent due May 15, 2018. The bond is rated B1/B+, and is callable in 2015. The U.S. high yield market suffered one downdraft in early August, and a second downdraft in late September. On Sept. 28, MPEL bonds were priced at 107.25; by Oct. 4, they were down to 87.50. This means the yield on the bond (yield to worst for all of you bond aficionados) rose from 8.33 percent to 13.13 percent — nearly five percentage points of additional yield. However, market liquidity began to recover during October, and those that needed to sell were mostly out of the market. The price has returned to 107.00 — a round-trip of nearly 20 points on each side. During such times of stress, very little trading actually takes place, as noted earlier. However, those managers who are prepared are able to move quickly to take advantage of such situations.
Our second example is a U.S. dollar-denominated emerging market bond — OAO Sovcomflot (SCFRU), a Russian energy transportation company that owns and operates tankers that carry oil and gas. The company is majority-owned by the Russian government. The bond in question is the 5.375 percent due Oct. 27, 2017. The bond is rated Ba1/BBB. Although the bond price deteriorated slightly during August and early September, the bulk of the decline hit about mid-September. On Sept. 16, SCFRU was priced at 97.875 for a yield of 5.79 percent. By Oct. 4, the bonds had dropped to 80.50, to yield 9.71 percent. Today, the bonds are priced around 91.50, to yield 7.15 percent.
Keep in mind that these were individual occurrences; many bonds held their value reasonably well during this time period, while some may have had even bigger price moves than the examples above. Furthermore, these are price moves of individual bonds. The NAV of the bond funds won’t move nearly as much as individual bonds in the funds.
There are two lessons to learn from the examples above, one for investors in bond mutual funds, and one for the portfolio managers of these funds. For the investor, the lesson is to not panic and sell your bond fund when the NAV is adversely impacted by temporary market forces. For portfolio managers, the lesson is to be fully aware of the risky nature of the current market environment and to keep a supply of cash and liquidity on hand to take advantage of big price moves in order to benefit the funds’ investors for the medium and long-term.
So, what should an investor do?
As mentioned previously, it’s important to remember the contractual nature of bonds. They will from time to time experience volatility in the pricing as our examples demonstrated, but at some point you get your money back, if held to maturity. In the current low interest rate environment — one that may last for a considerable period of time — investors need new sources of income. We believe corporate bond-oriented funds can provide just the ticket for taxable investors.2
Studies have demonstrated that individual investors receive returns far below the returns of both market indices and the reported performance of mutual funds.3,4 The primary reason for this is that investors overreact to market moves and financial news reports. Therefore, don’t succumb to panic; lower the cognitive dissonance created by the tsunami of excited but often misguided financial news reporting. Take a longer-term view. Secure a reasonable income stream while mitigating the risk of significant capital loss through prudent investments in corporate bond-oriented mutual funds.
So, to all of you investment hitchhikers out there, remember — Don’t Panic! Let us be your “guide” to a better investing future.
As of 9/30/2011, OAO Sovcomflot bonds accounted for 0.08 percent of the Waddell & Reed Global Bond Fund portfolio. The Fund did not hold a position in Melco Crown Entertainment.
1 The Waddell & Reed Advisors Global Bond Fund’s March 2011 Market Perspectives went into detail on why all bonds and bond funds are not alike. It discussed the possibility that bubbles might occur in some parts of the bond market but not others, and how the Waddell & Reed Advisors Global Bond fund uses shorter duration and corporate bonds to provide a reasonable income stream and reduce NAV volatility.
2 Although this note primarily addresses taxable corporate bonds, municipal high income funds work the same for the tax-exempt investor. For example, the Waddell & Reed Advisors Municipal High Income fund portfolio invests primarily in revenue bonds; the issuers of these bonds are typically stand-alone entities such as not-for-profit hospitals, continuing care retirement centers, or utilities. These entities generate revenues on their own and the bonds are not supported by the tax base of any government entity. Therefore, they generate a higher income stream than tax-exempt municipal government obligations and are analyzed similar to taxable corporate bond issuers.
3 See the Journal of Pension Benefits, Volume 16, Number 1, Autumn 2008, “The Tyranny of Choice”. This study utilizes the Dalbar “Quantitative Analysis of Investor Behavior” that has been done for 17 years. According to the Dalbar website, “Since 1994, DALBAR’s QAIB has been measuring the effects of investor decisions to buy, sell and switch into and out of mutual funds over both short- and long-term time frames. The results consistently show that the average investor earns less — in many cases much less — than mutual fund performance reports would suggest.”
4 A second example that details how excess trading hurts returns is the landmark study by the behavioral economist Terence Odean: “Do Investors Trade Too Much?”, The American Economic Review, December 1999.
Past performance is not a guarantee of future results. The opinions expressed in this article are those of the Waddell & Reed Financial Advisors and its fund managers, and are not meant to predict or project the future performance of any investment product. The opinions are current through November 15, 2011, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.
Consider all factors. Waddell & Reed Advisors Global Bond Fund: As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. These and other risks are more fully described in the fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers. The lower rated securities in which the Fund may invest may carry a greater risk of nonpayment of interest or principal than higher-rated bonds.
Waddell & Reed Advisors Municipal High Income Fund: Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in high-income securities may carry a greater risk of nonpayment or interest or principal than higher-rated bonds. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund may include a significant portion of its investments that will pay interest that is taxable under the Alternative Minimum Tax (AMT). These and other risks are more fully described in the Fund’s prospectus.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for the Waddel & Reed Financial Advisors, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.