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Bonds For All Occasions (I)

06/18/02 04:22:20 PM PST
by David Penn

Is there a fixed-income investment for every economic climate?

There are a number of gems in Mark Boucher's The Hedge Fund Edge. From his lucid discussion of the Austrian school of economics to his insights on asset diversification into global equities and managed futures, Boucher's 1999 text deserves a place on the bookshelves of all types of traders and investors, be they fundamentalists or technicians.

Boucher's discussion on bonds and fixed-income investment is especially of note. While an understanding of the role that bonds and fixed-income investment play in a fractional reserve system (such as the US with its Federal Reserve Board) is helpful, those familiar with the basics of inflation and interest rates likely will find Boucher's observations compelling. Because there are fixed-income "bets" that provide investors with higher-rate returns in an environment of falling interest rates, and fixed-income "bets" that allow investors to take advantage of increases in, for example, rising short-term rates, bond and fixed-income investors (or investors who have significant bond or fixed-income allocations in their portfolios) have much more flexibility in responding to market conditions than conventional wisdom would suggest. As Boucher concludes:

The key points here are (1) there is almost always a bond investment making money in any kind of imaginable environment; and (2) if you can reliably determine which way interest rates and the economy are heading, you can adjust your bond investments to profit from the environment.

The second point is one that should be encouraging to traders and investors with a technical bent, as well as those familiar with the Fed liquidity cycle (Boucher refers to it as the "Austrian liquidity cycle") in response to which interest rates tend to rise and fall. Technical charting methods can be an effective way to, for example, anticipate changes in bond prices. Insofar as bond prices move inversely to bond yields, technical methods can help investors and traders profit from changes in bond yields.

However, it is Boucher's first point this article will address: the effectiveness of various bond types — from zero coupons and junk to Ginnie Maes and emerging market debt — over the past four or five years of a bull market in financial assets, followed by a bust and a bear market. Looking at long-term price charts of mutual and closed-end bond funds, we will try to find technical support for Boucher's thesis that somewhere some bond is making some savvy investor a ton of money.


Boucher looks at 13 different bond types in his study. Here, we will look at just the more common bond types, as well as those that represent a certain "bet" on interest rates and economic growth. The goal will be to establish a series of bond/fixed-income investments that would theoretically keep an investor profitable from the beginning of an economic downturn, down into recession, back up into recovery, and back to a market peak. The bonds and fixed-income funds we will examine in this first installment include zero coupons, long-term bonds, short-term bonds, and international bonds. In particular, after introducing the different types of bonds and bond funds, we will look at how each bond type fared in the period between 1998 and 2002.


By definition, zero coupon bonds do not pay periodic interest over the life of the bond (thus the "zero"). Instead, zero coupon bonds pay both principal and interest upon the maturation of the bond. The idea behind zero coupon bonds, which were introduced in the early 1980s, was to strip the interest rate payment from the principal amount, package the interest rate payments and the principal amounts, and sell them as two different investment products.

The best time to buy zero coupon bonds is when lower interest rates are anticipated, particularly if rate-cutting is assumed to be quick. In such scenarios, zero coupon bonds are almost an unbeatable fixed-income investment. Note, for example, how the American Century Benham Target Maturities 2025 Investor fund (BTTRX) — a fund that specializes in zero coupon bonds — performed from May 2000, when the Federal Reserve Board's Fed funds rate peaked at 6.5%, to late 2001, after that same rate had been slashed to 1.75%.

Figure 1: BTTRX. This zero coupon bond fund soared when the Fed funds rate peaked in May 2000.

As you can see, BTTRX bottomed precisely in January 2000, rallied and then fell again, establishing a major higher low with the decline of May 2000. From the higher low in May 2000 to the end of the year, BTTRX tacked on nearly 19%. BTTRX corrected sharply in the spring of 2001, but went on to make even higher highs by autumn, concurrent with the financial panic in the wake of the September 11th terrorist attacks in the US.


Long-term bonds include both long-term government bonds such as Treasuries, as well as longer-term corporate bonds. All things being equal, the upside for long bonds is clear: consistent income over the duration of the bond's term, with a repayment of principal (plus any appreciation) upon maturity. While long bonds in the late 1990s appeared to take a backseat to the soaring equities market, long bonds have performed well during the bull market that resumed in the wake of the 1990-91 recession (the relief rally in 1992, and the bull market advance from mid-1994 to 1999).

The downside for long bonds is, in a word, inflation. Not only does inflation eat away at the principal amount that has been lent out, but rising inflation makes what was a compelling interest rate at one time almost a worthless interest rate at another. The reason for this is the difference between real and nominal interest rates. The nominal interest rate is simply the quoted rate at the time. If you see a certificate of deposit paying 3% interest, that 3% is considered the nominal rate of interest. The real interest rate, however, is the rate of interest less the rate of inflation. In an environment in which inflation is running at, for example, 1.5%, then the real interest rate is 1.5%, the 3% nominal interest rate less the 1.5% inflation rate.

Figure 2: VBLTX. Lower interest rates helped this long bond fund make major gains in 2000-01.

One of the ways inflation expresses itself in the economy is through rising interest rates. Actually, it is more accurate to say that rising interest rates are one of the primary ways to fight rising inflation. The significance of this to the bond market in general and the long bond in particular is that rising interest rates make current bonds (paying lower interest rates) less attractive. After all, who wants a 10-year bond paying 4% when there are 10-year bonds paying 5% or 6%?

Take a look at the chart of the Vanguard Long-Term Bond Index fund, a mutual fund that invests almost exclusively in long Treasuries and corporate bonds. Most obviously, note how VBLTX makes a bottom in the spring of 2000 — around the same time that the zero coupon bond fund (BTTRX) made its bottom. The bottom in VBLTX comes after a major bear market from 1998 through 1999. In 1999, you may recall, the Federal Reserve Board began raising the fed funds rate, a campaign that did not end until the middle of 2000 with a rate of 6.5% after six consecutive hikes. As difficult as this environment was for long bonds, the peaking of the fed funds rate in May 2000 was almost as much a boon for long bonds as it was for zeroes. VBLTX rallied from its May 2000 bottom to end the year up more than 12%.


From short-term Treasuries to investment-grade corporate bonds, short-term bond funds are best suited for those with heightened sensitivity to interest rate risk. Where a long bond fund investor would cringe in an environment of advancing interest rates, a short bond fund investor would be comforted knowing that the shorter maturity bonds in the fund would be replaced by additional short maturity bonds with steadily higher interest rates. At the same time, as Werner Renberg observes in his All About Bond Funds, "When interest rates fall, the dividends they pay also tend to fall more sharply than those paid by riskier long-term funds as their maturity securities are replaced sooner by lower yielding ones."

Short-term bond funds are, by nature, more geared toward capital preservation than dramatic capital gains. In addition to capital preservation, most short-term bond funds also seek to provide consistent income. Short-term bonds then are an ideal vehicle for conservative or safe haven investing, such as during periods of economic uncertainty or questions about the direction of interest rates. Boucher refers to short-term bonds as "anchor position[s] — they will give you an extremely reliable positive return, but will also keep you from making double-digit profits if you own too much of them."

Figure 3: BTSRX. More a hybrid than a true short-term bond fund, this fund suffered when interest rates stopped moving up in 2000.

From 1999 to the present, as the chart of BTSRX (Deutsche Bank's Lifecycle Short Range fund) suggests, short-term bonds performed consistently, if not spectacularly. Note in particular the severe drop in BTSRX in the autumn of 1998. This collapse is concurrent with the added liquidity the Federal Reserve Board supplied the markets with in the wake of the Russian debt default/Long-Term Capital Management implosion. If you recall the particular danger to short-term bond funds — that falling interest rates mean that old bonds will be replaced with new bonds paying less in interest — then there should be little surprise that funds like BTSRX sold off sharply when the Federal Reserve Board, after leaving short rates at 5.5% for a year and a half, began lowering the Fed funds rate (which bottomed at 4.75% in November 1998 and remained at that point until the Fed began raising rates in June 1999).

Note how BTSRX begins to show strength in the autumn of 1999 and begins to climb. However, with the spring 2000 peak, and the Federal Reserve's new commitment to lower short rates, the rally in funds like BTSRX stalls, and prices begin to drift back down.

In some ways, BTSRX is an atypical short-term bond fund because the fund managers reserve the right to invest as much as 30% of the fund in common stock. However, comparing BTSRX with another short-term bond fund, such as Pimco Short-Term Bond Fund, shows significant similarities. Those are most pronounced where both funds bottom in late 1999 and enter 2000 in a rally mode.

What is interesting about the Pimco fund, PSHAX, is that it managed to carry its 2000 successes into 2001, a year characterized by the sort of falling interest rates that usually spell underperformance for most short-term bond funds. Boucher considers short-term bond funds to be "too conservative" during periods of falling interest rates, when so many other bond types do well. But the results of PSHAX (like those of Vanguard's Short-Term Bond fund, VBISX) suggest that solid, if not spectacular, performance from short-term bonds is possible even when rates are in fact falling.

Figure 4: PSHAX and VBISX. These true-blue short-term bond funds from Pimco and Vanguard turned in impressive performances in both 2000 and 2001.


International bonds funds invest in the debt securities of countries around the world. International bonds are generally in a separate class from what are often called "emerging market bonds," which usually reflects the better investment grade of bonds from economically developed countries. These countries include nations such as France, Japan, Canada, Switzerland, and the United Kingdom. Why invest in bonds from other economically developed countries? Annette Thau, writing in The Bond Book, suggests there are plenty of arguments against the practice.

If I had to pick the most beleaguered bond fund manager, the manager of an international bond fund would be a strong candidate. . . . Consider his dilemma. Bonds issued by foreign corporations or foreign governments are subject to the same risks as US securities: credit risk and interest rate risk; and these vary enormously from country to country. But international bond funds are subject to additional risks. The most important of these is currency risk since bonds are purchased in American dollars . . . There is also what is known technically as sovereign risk; that is, the risk deriving from the political and the economic system of foreign countries, some with highly unstable governments, and even less stable economies.

As such, Thau considers international bond investing, essentially, to be a "bet against the dollar . . . prosper(ing) when the dollar declines against foreign currencies."

Figure 5: RPIBX. As the US dollar continued to climb in the late 1990s, international bond funds such as this one faced significant declines.

Note the performance of the T. Rowe Price International Bond fund (RPIBX) since 1998. Although there is the possibility the fund is establishing a bottom in the 2001-01 period, from 1998 to the summer of 2001 RPIBX was in a major bear market, losing 28% over that time. What is interesting in light of Thau's thesis on the relationship between international bonds and the dollar is that the greenback crashed in the autumn of 1998, just as RPIBX was making a top. As the greenback became stronger in the late 1990s, international bonds — as a "bet against the dollar" — lost big.

When it comes to international or foreign bonds (speaking mostly about longer terms), Boucher looks for the inverted yield curve — signifying that short-term rates are pushing long-term rates down — as one of the factors that alert international bond investors to a new opportunity. Why does this represent an opportunity? Boucher explains:

In any country where a recently inverted yield curve is followed by evidence of economic slowdown, watch carefully for a strong bond market trend as a signal to go long bonds. This combination often leads to the longest and strongest bond bull moves. Such signals are usually heralding the beginning of the end of a recession, growth recession, or soft landing.


What does this look at zero coupon, long-term, short-term, and international bonds suggest about what is often referred to derisively as "bond timing"? Whether moving away from bond types that are likely to underperform and moving toward bond types that are likely to outperform constitutes "bond timing" or merely sound investing is another question. But there is no doubt the advantages are great for those bond investors who, committed to getting more bond for their hard-earned dollars, make sure their debt instrument is the one best able to produce positive returns.

Thus, whether or not it is "timing," it makes little sense to invest in international bonds at a time of great dollar strength — unless the investor is anticipating a near-term reversal in the fortunes of the greenback. Short-term bond funds can be effective for taking advantage of rising interest rates for many of the reasons stated, but a declining interest rate environment means that short-term bond funds are replacing their short-term bonds with even lower-yielding short-term bonds when the previous bonds reach maturity. Long-term bonds and zero coupons are the best bond bets when inflation is not a threat and interest rates are expected to fall. This makes the yield on current long bonds all the more attractive. Zero coupons are considered the turbo-powered approach to exploiting falling interest rates, and — as shown above — can be more effective than any other form of fixed-income investment when rates begin falling swiftly.

More than anything else, however, this review of bond types should suggest some meaningful alternatives to those whose portfolios are overweighted in equities and underweighted in bonds (Boucher himself admits that, compared to equities, "adding long bonds to a portfolio since 1981 has done little except cut total returns when combined with US equities").

However, the variety of types of bonds investors can seek out — a variety that can enable investors to take better advantage of changes in economic conditions (compared to equities) — tends to mute this kind of criticism. The diversity of fixed-income investments is such that shrewd investors — be they cautious or risk-seeking — will always be able to find effective bond tools in which to trust their hard-earned bucks.

David Penn may be reached at


Boucher, Mark [1999]. The Hedge Fund Edge, John Wiley & Sons.

Renberg, Werner [1995]. All About Bond Funds, John Wiley & Sons.

Sease, Douglas, and John Prestbo [1999]. Barron's Guide To Making Investment Decisions, New York Institute of Finance.

Thau, Annette [1992]. The Bond Book, Probus Publishing.

Charts: MetaStock (Equis International)

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