Wednesday, October 11, 2006

The Case for Bonds: Part I - Only the boring survive

2006 has seen the introduction of many toys for the "Global Macro Hedge Fund in my E*Trade Account" crowd. ETF sponsors have wrapped all sorts of exotic assets such as foreign currency, precious metals, emerging markets, commodities, and short positions into ETFs. The previous obscurity of these asset classes kept them safely out of the hands of retail investors.

The main asset class that the fast money crowd ignores is bonds. This is only to their loss. I don't think I can say it better than PIMCO, on the role of bonds in an asset allocation strategy:

Bonds can play an essential role in asset allocation by diversifying risk, generating income, and preserving wealth across a range of economic and financial market conditions that can cause wide fluctuations in stocks and other asset classes.

Bonds act as ballast for portfolio. They give your ship stability in rough waters and prevent it from becoming top heavy and unstable.
The Benjamin Graham recommended that investors should always have at least 25% allocated to high quality bonds. For most investors he felt the target allocation should be even higher.

Now (mid October 2006) the stock market is making new highs, it is a good idea to rebalance and make sure that you are invested in harmony with your risk tolerance. Investing in bonds as an asset class is too complex to do by yourself. Hence the need for a cheap and well managed bond fund.

The problem with the passive bond ETFs is that they can not pick up obvious alpha via duration management (i.e. they don't adapt to an inverted yield curve) and they can't exploit spreads between equivalent risk bonds. Without the ability to dynamically reposition the portfolio or hedge interest rate risk, bond ETFs tend to get quite bouncy. Maybe too bouncy for most investors.

Thought by many as the best fixed income manager of the past 25 years, PIMCO's Bill Gross manages the PIMCO Total Return Fund (PTTDX), with $93 Billion in assets. PTTDX is core bond fund with an intermediate duration and average AAA credit rating. This fund is suitable for all investors.

PIMCO is also the leading subadvisors for bond mutual funds rn by other companies. Bill Gross's team also manages the Managers Investment Group's Fremont Bond Fund (MBDFX) and Harbor Bond Fund (HABDX). The Fremont Bond Fund is on the no transaction fee list at most online stockbrokers including Scottrade. Both of these funds have the same strategy as the name brand PIMCO Total Return fund (charging 0.75%) but charge 0.60%.


At October 12, 2006 2:09 PM, Anonymous Anonymous said...

bond funds? the obvious knock is that holding real bonds is better. no risk of capital depreciation unless you plan to sell them. everyone knows this. i say this because i'm perplexed and take you seriously and want to explore the fixed income asset class of which i'm floundering. another blogger has recommended "2 yr foreign bond funds " i suppose for the purpose of currency differences and diversification/lower correlation. what do ya think..have a recommendation...sort of two questions here...and a third...DBV is seductive, but i think i saw you knock this one real hard. can you elaborate or is it just an issue of too early to trust such a complicated vehicle? thx.

At October 12, 2006 8:24 PM, Blogger Market Participant said...

The problem with holding single bonds is that it is expensive. Both because bonds usually have a par value of $1000 and because commisions are very high. To assemble a decent portfolio you would have to buy about 10 different bonds, thereby tying up at least $10000 and probably paying about 4% or so in transaction costs. Bonds are also *very* illiquid for retail traders. Huge B/A spreads

In that case it makes sense to hold a single CD instead. Compared to CD, a bond fund tends to pay a market rate of interest, and is more liquid/investable. I.e you can add to it at any time

If you don't want to own an active bond fund, you can just buy shares of (AGG). However a good bond can do better, or do the same with slightly less bounciness. The PIMCO funds that I recomended, tend to be of the do the same but less bouncy type style.

PIMCO PTTDX fund card. As you can see the fund has beat the AGG over time

For foreign bonds the best pure play on that is PIMCO Foreign Bond Fund (Unhedged) (PFBDX). Since interest rates outside the US are fairly low, Foreign Bond Funds don't attract as much investor interest as they should.

If interest rates were to fall, or the dollar decline such a fund would provide alot of excess return. Iterest rates outside the US tend to operate on slightly different credit cycle. Because of the triple action, such a fund is a spice and not a main dish.

DBV I think would work out quite well, but I'm just unclear as to how the ETF works. Does it pay dividends? Do you get a form K-1/1099-INT(DIV) its just to unclear. But the core strategy works out quite well over time.

At October 12, 2006 11:27 PM, Anonymous Anonymous said...

From what I understand, DBV per index universe's article, dated only a few days ago, the yield minus the expense should amount to 3 point something percent. Yes, it seems you do get interest plus appreciation and the price since inception is a stable uptick.I would be holding it in a 401k account, so taxable issues are not relevant for me.

At October 15, 2006 2:35 PM, Anonymous Kim Snider said...

All income producing investments serve an increasingly important function in a portfolio -one Benjamin Graham didn't need to talk about.

Our biggest asset is not our house or our portfolio. Our biggest risk is not the housing bubble or market risk. Our biggest asset is our human capital and our biggest risk is a disruption in our income due to disability or obsolescence.

Income producing securities hedge this risk - paper gains do not. You can't eat paper gains.


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