The "Corona-Adjusted" Outlook for Bonds

by Tom Madell

The coronavirus has thrown the ordinary world out of whack. So it is no surprise that it has seriously impacted investors. But apart from the already visible effects to investors, the most striking changes, although still uncertain, may be yet to come. So what can an investor do, if anything, to prepare?

The stock market has been acting like a yo-yo, almost enough to drive one crazy. Some current investors might conclude they should sell, or at least lighten up, while more aggressive types are perhaps licking their chops at what they consider great buying opportunities. Of course, it all likely depends primarily on your goals as an investor: For avoiding worry and possibly sleeping better at night, you might want to sell some stock; for planning on perhaps making an easy profit on funds that haven't been this low in years, you might want to buy some.

But these drivers of such actions probably reflect more of a narrow, short-term perspective. Over the longer-term, if you can maintain the same patient outlook you might have had prior to the crisis, you may not be impelled to do anything right now. Thus, waiting for stocks to return their more normal ways, that is variable but not heart-poundingly so, as they inevitably will, is probably the best course of action for most.

Would the same relatively unchanged strategy apply when considering bond fund investments? Here things may suggest a somewhat more modified approach.

For many bond investors, bonds can serve as a ballast to your stock investments. According to the dictionary, a ballast is something that helps you to succeed, especially by keeping the overall circumstance under control.

Investors in bonds hardly ever would expect a bond fund or ETF to greatly grow their overall wealth. Rather, by providing a more stable counterbalance to one's stock portfolio, one is less likely to experience their entire portfolio falling in unison, thus helping their investors to maintain the stock portion of their portfolio until more normal conditions return.

Of course, many investors choose bond funds for an entirely different reason. Bond funds can provide a measure of extra or necessary income, generating regular monthly payments in the form of dividends. While some bond funds can still boast somewhat hefty payouts, with interest rates currently so low now, these dividends have been reduced far below what they may have paid in the past.

But it should be noted that investing in bonds, especially in some types of funds, is not without significant risk. If the type of bonds in the fund's portfolio is out of favor, the fund can lose value and therefore if you need to sell shares, you may in effect be cancelling out much or all of your accumulated dividends. While you may still receive your dividends, diminished net asset value (NAV) may cause your overall investment to be worth less today then when you purchased it.

Investment Implications

Whether your goal is to use bonds as a ballast or to earn extra income, you should consider carefully which bond fund(s) you choose in order to achieve your goals. And as external circumstances change as they have recently as a result of the coronavirus, you may want to reduce ownership of certain types of bond funds while increasing ownership of others.

But before I consider which types of bond funds you may want to currently emphasize in a portfolio in light of the potential future impact of the virus, let's take a look at the overall investment environment of which bonds are a part.

Considerations

• Interest rates are now at record lows. As a result, you will get virtually nothing back from money in money market funds. Of course, at least as of yet, such investments are not losing money, as have most stock funds since the beginning of the year. For example, most money market funds are now paying in the vicinity of just 1/2 of 1 percent. (Note: the temporarily high money market interest rates mentioned in last month's Newsletter have proven to be only a quickly passing effect of the crisis.)

• Dividend yields paid by most bond funds are also quite low, although not as low as money market yields.

  For example, the by far largest bond fund, Vanguard Total Bond Market Fund Adm (VBTLX) (or ETF (BND) ) are currently paying about 1.6% annually. But in spite of the low dividends, most bond funds have had a total return (dividends plus price appreciation) that is considerably larger. Thus, both VBTLX and BND have returned approximately 11.3% over the last 12 months, and over 5% since the beginning of the year.

  At first, this may seem hard to understand, but a fund's total return is not just determined by yield, but also by investor demand. In spite of low yields, investors have been pouring money into bond funds for their perceived safety as compared to stocks. As demand for an asset increases, so does the NAV of most bond mutual funds. Also, in response to the crisis, extremely aggressive Federal Reserve bond purchases are responsible for driving up the price of bonds, although driving down the yield. So it is still possible for bonds, unlike money market funds, to excel in a low interest environment in spite of the low yields.

• While all bond funds have at least some degree of risk, certain types of bond funds are much riskier than others. Therefore, if you do own one or more bond funds, you should be aware of where they stand on a continuum of very low risk to much higher risk. Further, some bond funds are more sensitive than others to the ups and downs of the economy as well as rising or falling interest rates and inflation. Thus, if the economy takes a relatively long time to recover from the current crisis, as some although certainly not all economists fear, most, but not all bonds, will wind up doing better than if the economy recovers quickly.

Prospects for Different Types of Bond Funds/ETFs

Note: Many bond funds consist of a variety of different types of bonds. But most are predominantly one type or another; check at the fund's website if you are unsure.

Short-Term Government

Short-term government funds are probably the least likely to generate losses, regardless of the investment environment. However, they also tend to have the lowest dividends, investing predominantly in US treasury holdings. These bonds will fill the bill for the most conservative of investors. In the unlikely event that interest rates rise quickly, they, unlike most other categories, may only suffer small loses, considerably less than the remaining categories.

Appraisal: Over prior years, short-term government bond funds have tended to go somewhat in the opposite direction as the US stock market. So if you are worried about stocks, these may be the way to go. However, rates are so low that there is only limited appeal to this category.

Intermediate-Term Government

These funds typically have a slightly higher dividend yield than short-term government funds. They include not only treasury bonds but GNMA (mortgage) bonds. Over the years, these funds have performed a little better than short-term bonds.

Appraisal: Probably the best prospects among government bond funds, combining higher yields with possible NAV appreciation.

Long-Term Government

These funds have been far and away the best bond fund performers over the last 10 years or more (also recently - see above), even approaching the returns of US stock funds. However, with interest rates already so low, there is a big risk that if and when rates rise, even by just a percent or two, they will suffer poor total returns in spite of paying higher dividends than the above two categories.

Appraisal: Since interest rates are unlikely to rise for perhaps at least a year or two, losses on a total return basis may not be a big immediate threat. However, owning a long-term treasury bond fund in most cases, especially now, should be undertaken mainly by highly aggressive investors with more of a short-term profit orientation.

Corporate

High quality corporate bonds (also called investment grade bonds) typically pay a higher dividend than similar length maturity government bond funds. For example, the Vanguard Short-Term Corporate Bond Index Admiral fund (VSCSX) currently pays 2.45% while the Vanguard Short-Term Treasury Index Admiral Fund (VSBSX) only pays a meager 0.19%. However, corporate bond funds are considered somewhat more risky than government bond funds because corporation bond performance may be negatively affected by a deterioration of the economy.

Appraisal: Longer-term corporate bonds have been performing better than shorter-term corporate funds during the long-term decline in interest rates, but as with government bond funds, the longer-term bond will likely suffer more once interest rates eventually rise which is highly probable once the coronavirus crisis subsides.

High Yield Bonds

These are also corporate bonds, but of lower quality than the above category. They are sometimes referred to as "junk" bonds. Why? In this case, the quality is determined by rating agencies based on the financial strength of the issuing company. Lower quality bonds are considered somewhat more likely to be unable to repay investors the dividends they have promised or even to default altogether. Given this higher level of risk, such issues need to offer a higher dividend yield than other more creditworthy bonds. Over the last 10 years, these bonds have generally outperformed higher quality corporate bonds, but more recently, their performance has started to lag, especially since the COVID-19 crisis began. Another risk: High yield funds, unlike most other bond funds, are usually positively correlated with the overall US stock market. This means lower NAVs if stocks and the economy continue to be weak.

Appraisal: If stocks continue to underperform from prior years as I expect, it is somewhat likely that these bonds won't do well either. In selecting such a fund, look for one with a high percentage of "BB grade" bonds; if unsure, check at the fund's website.

International Bonds

These bonds can be either government and/or corporate bonds from countries around the world. They have done quite well over the 10 years through Dec. 2019, as compared to US bonds. However, this year so far things have reversed with international bonds fading quite a bit. Perhaps this is because international bonds are perceived as riskier than US bonds and many investors are interested in reducing risk right now.

Appraisal: The COVID-19 crisis has likely made investors around the world favor US bonds as opposed to international ones. Extremely low or even negative interest rates in many foreign countries lessen the chance for above average returns.

Municipal Bonds

Tax-exempt municipal bonds generally perform in line with the overall taxable government bond market but with somewhat higher after-tax results for many investors. However, over the last year, muni bonds have lagged behind.

Appraisal: Unless the Federal government provides substantial additional aid to states, many states (and localities) will suffer from severe financial shortfalls due to reduced tax-related inflows and higher spending levels to support their citizens, primarily as a result of the coronavirus job layoffs and lockdowns. This could likely cut into investors' willingness to buy and hold on to these types of bonds. But further down the road, tax rates may rise in order to help states balance their budgets, which might drive investor demand in order to seek out the tax-free income they offer. The result may be a mixed bag of performance for these funds.

Inflation-Protected Bonds

Inflation would seem to be the last thing to worry about now. But since these funds are composed of US government bonds which are adjusted for inflation, they have ridden the strong bandwagon for US bonds.

Appraisal: While there is very little inflation now, the ever-expanding US budget deficit compounded by the crisis, may lead to somewhat greater inflation down the road, enhancing the attractiveness of these bonds.

Emerging Market Bonds

These are among the riskiest bond funds one can own. They tend to be highly correlated with US stocks and also with emerging market stocks. Such funds tend to do best when the US dollar is weak; however, that is not the case now as investors worldwide flock to the perceived greater safety of US investments. These funds pay a high dividend, but so far this year, they have done very poorly on a total return basis, exacerbated by the crisis.

Appraisal: Looking ahead, I would avoid these investments except for highly risk-tolerant investors.

Need mutual fund questions answered? In this perplexing time for investors, you may be unsure of how to deal with your investments. I will try to briefly answer all questions received. Contact me at funds-newsletter@att.net

---

To sign up to receive notification of new Newsletter postings, click here.

---

If you find this month's Newsletter helpful, consider pasting this link to it in an email to a friend:
            http://funds-newsletter.com/may20-newsletter/may20.htm