Bond investors have been challenged thus far in 2018. As of the end of April, according to Morningstar, 90% of municipal bond funds and 73% of taxable bond funds were under water for the year. This might not come as a total surprise, as the Fed has raised interest rates 4 times since March of 2017 and has hinted that at least 2 more hikes will occur before the end of the year.
The current environment presents a challenging environment for investors seeking an income stream in conjunction with the (misperceived) safety of the bond market. With rates held at artificially low levels for nearly a decade, a compelling yield has been tough to come by without taking on the risk of certain high yield or international bonds or even dividend-paying equities.
We have found that by approaching the bond market as one might the equity market, in this case using “sector rotation,” risk may be reduced. The key is identifying bond fund classes which are not highly correlated to each other, pay a significant yield, and display the propensity to trend. Some refer to this phenomenon as “serial correlation,” which can be used to describe the tendency of a particular issue to move in the same direction from one day to the next. We’ve done a lot of research on this, and have found that municipal bonds, high yield corporate bonds and mortgage-backed (MBS) bond funds all share these characteristics. It is worth noting, too, that within each of these sectors interest-rate risk can vary wildly. For example, in 2008 Nuveen High Yield Municipal Bond lost over 40% of its value, whereas Nuveen Limited Term Municipal Bond gained 1.2%.
Of course, recognizing this, and acting on it, are two different things. We believe that by using a systematic approach that centers around price action (performance), one can construct a system of buying those bond funds which are showing the strongest movement and just as importantly avoiding those which are not. And while currently, such an approach may not generate an eye-popping yield, it may well give you a more stable return and less downside volatility. If bonds begin to rise, this type of system could seamlessly rotate out of the lower yielding, shorter duration funds, and into positions with higher yields. The market will reward the patient, and remember: a low yield with safer investments might be more appealing than a higher yield with the risk of a significant loss of principal.