Little Solace in Bonds

Seeking Solace? You’ll Find Little In The Bond Market

By Jeff Sommer | 22 November 2008

A worker outside the London office of Lehman Brothers. The firm’s collapse forced liquidations of bond holdings by major institutions— and investors became wary of many classes of bonds.

When your safe haven comes under attack, you’re really in trouble. But that’s what has happened this year to many investors, as some bond portfolios have taken enormous hits, The New York Times’s Jeff Sommer writes.

It’s bad enough that the stock market has plummeted. Even with a late-day rally on Friday, the Standard & Poor’s 500-stock index is down more than 45 percent for the year to date. Stocks have not declined that much in a full year since 1931.

But see First Year Of Major Correction [Right] (Dow, as percentage, since 1900) Source: ChartoftheDay

But bonds? They’re supposed to be the Steady Eddies of a well-diversified portfolio— safe, boring and a necessary part of an investor’s diet, like spinach, Mr. Sommers notes. The excitement— and risk— in a portfolio should come from stocks. If bonds fluctuate at all, they are expected to rise in value when stocks decline, buffering a portfolio’s returns in a rocky market. That, at least, is the common expectation, said Robert L. Rodriguez, chief executive of First Pacific Advisors and co-manager of the FPA New Income mutual fund.

But the global credit crisis has shattered the expectations of many investors in fixed-income as well as equity markets. With forced liquidations of bond holdings still under way by major institutions in the wake of the Lehman Brothers failure in September, even the slightest whiff of risk in a bond has put off investors, resulting in big losses. And bonds are certainly not a sideshow: Much of the turmoil in the financial sector and the overall economy has emanated from the credit markets.

So far, only the most unimpeachably safe fixed-income securities— for the most part, those issued by the Treasury or otherwise backed by the United States government, directly or indirectly— have generally held their value. "Investors are confused, and they have a lot of misconceptions," Mr. Rodriguez told The Times. "You have to get to the basic question, and that is, which bonds do you actually own?"

Long-term corporate bonds, for example, declined in value by more than 18 percent, on average, through October, according to Ibbotson Associates, a Morningstar subsidiary. That’s worse than any full-year decline on its records going back to 1926. The rout in corporate bonds, particularly high-yield or junk bonds, has been worse, by some measures, than even the distressed market of the Great Depression, said William H. Gross, co-chief investment officer of the Pacific Investment Management Company. Junk-bond yields— which move in the opposite direction of prices— recently soared above 20 percent.

"These are unheard-of, unseen yields that have never taken place in anyone’s lifetime," Mr. Gross, who manages Pimco Total Return, the country’s largest bond fund, told The Times. "Even during the Depression, corporate bonds did not trade at these particular yield spreads," or premiums over yields of comparable Treasuries, Mr. Gross added. On the positive side, long-term government funds tracked by Morningstar were up 9.2 percent for the year through Thursday.

But in many parts of the market, the returns for bond mutual funds are sobering, with performances that would be abysmal even for stock funds in a typical year. High-yield bond funds were down 29.6 percent for the year through Thursday, emerging-market bond funds were off 26.5 percent, and bank loan funds were down 24.7 percent. Even intermediate-term bond funds, a middle-of-the-road category often used as a core holding for portfolio balancing, were down 9 percent.

This is no typical year, however, not by a long shot, Mr. Sommers says. "Never before, in 25 years, have I seen conditions like this," Mary J. Miller, the director of T. Rowe Price’s fixed-income division, told The Times. "It’s not just credit risk," she said. "Some parts of the market are liquidity-impaired— there just aren’t enough buyers out there."

Municipal bonds have been "considerably punished," she said, because of a lack of buyers and the "acute risk aversion" that has permeated the market. Most municipal bonds are, in fact, creditworthy, she said, but their prices have gone down anyway. The loss of independent firms that functioned as market makers— like Bear Stearns, Lehman Brothers, Merrill Lynch and Wachovia— has disrupted markets, she said, and so has the continued unwinding of leveraged bets, often packaged as complex derivatives, taken by hedge funds.

Mr. Gross of Pimco described the wave of selling by hedge funds as akin to "a margin call" in which bond holders are forced to sell securities at lower and lower prices. Still, some bond funds marketed as core holdings for buy-and-hold investors have held their own this year. In the current market, that means not losing much money, and, in some cases, maybe gaining just a little.

These funds include Pimco Total Return, which was down 0.3 percent through Thursday; the Vanguard Total Bond index fund, up 0.9 percent; the T. Rowe Price New Income fund, down 2.3 percent; and FPA New Income up 3.7 percent. All of these funds are highly rated by both Morningstar and Lipper. This modest performance was possible because these funds did not dabble much, if at all, in risky areas of the market, said Jeff Tjornehoj, senior research analyst for Lipper. "Funds that did well in up-markets by taking on risk have been punished now," he told The Times.

There are many ways of minimizing risk. The Vanguard Total Bond index fund is passively managed, and mirrors what until recently was known as the Lehman Aggregate Bond index— and is now called the Barclay’s Aggregate Bond index, as a consequence of Barclay’s absorption of Lehman’s bond analysts and indexes. Treasuries within the index gained in value while corporate bonds fell, and the results have been "about what you might have expected from a core holding," Fran Kinniry, who runs the investment strategy group at Vanguard, told The Times.

FPA New Income has taken a different approach, holding large quantities of cash and Treasuries, and keeping the average duration— essentially, the time before a security matures— down to about one year. Reducing duration cuts down on the risk of shifts in yields and inflation expectations. Pimco has taken another tack, by buying Treasuries and investing in fixed-income securities of Fannie Mae and Freddie Mac, the mortgage giants that have been bailed out by the federal government. "We’ve essentially made ourselves partners" of the government, Mr. Gross told The Times.

Mr. Gross is taking a similar approach, he said, with investments in the preferred shares of bank holding companies in which the Treasury is injecting capital. With a shortage of liquidity, and an epidemic of risk-aversion, he said, it makes sense "to buy something where you can partner with Uncle Sam as opposed to being left out in the cold."

With commodity prices declining and the Consumer Price Index dropping in October by the greatest amount on record, there are signs of disinflation, perhaps even the possibility of a cycle of declining prices, known as deflation. Bond strategists caution, however, that the current outlook for inflation has been made murky by the attempts of the Federal Reserve, and of central banks and governments around the world, to pump money into the financial system in an effort to strengthen the global economy.

For Mr. Rodriguez, this is a major concern, and further reason to minimize all of his bets. "We may be facing deflation first, and then inflation down the road," he told The Times. "This is a very difficult time." Mr. Gross said that for months to come, he expects the bond market to be struggling to evaluate the risks of both deflation and inflation. "It’s a legitimate debate," he told The Times, "and we don’t have any clear view as to which one wins."

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