How to Switch to Safety With Bonds and Bond Funds

I'm often asked about trade ideas that I've mentioned in my columns. Many readers, however, aren't actively trading bonds or bond funds, and instead buy them for the traditional reasons. But with the risk of increasing interest rates, many are now seeking ways to maintain safety without just going to cash and earning nothing. Here are my best ideas on how to achieve maintain safety, as well as strategies to avoid. Mortgage Bond Funds Personally, my favorite approach is government-backed mortgage bonds. There are many funds and a few exchange-traded funds, such as iShares MBS exchange-traded fund , that cover this space. First the easy part: Mortgages yield much more than most other shorter-term bond segments. The duration of the MBB is currently about 5 years, which implies it has about the same interest rate rise as a 5-year Treasury, corporate or municipal bond. However, the yield of MBB is much higher. I use the portfolio yield, for example the yield of all the bonds currently held by the ETF, which is more forward-looking that the distribution yield, which is 1.98%. That compares to about 1.15% for a generic A-rated corporate bond, 0.42% for a AAA-rated municipal and 0.78% for a Treasury bond. Even if you pay the maximum federal tax rate, the MBB still yields more than the municipal, and given that it is backed by the federal government, arguably MBB has less credit risk. Mortgage-backed securities also tend to perform relatively well when interest rates are rising. Using the Bloomberg Barclays MBS Index as our proxy, MBS have outperformed the a duration-matched set of Treasury bonds in 70% of quarters where rates rose since 2010. This is because as rates rise, mortgage borrowers are less likely to refinance. If they don't refinance, investors get to keep more of their interest. So in essence, MBS have a fairly low duration in the first place, and most of the time they perform a bit better than their duration suggests when rates rise. And with all that, they have more current income generation than most other sectors. I think that's a pretty darn good combination in this environment. So what's the catch? MBS tend to perform much worse than other bond types when rates fall, especially if they fall substantially. This can make MBS a worse hedge against equities than other bond types. However, in the current environment, this is less of a concern. The other issue with MBS is that spread changes tend to be very small. This means there are usually not many capital appreciation opportunities, whereas sectors like corporate bonds can appreciate meaningfully. However again, today's environment that's not a concern. Corporate bond spreads are already near all-time tights. Short-Term Corporate Bond Funds Probably my second favorite option would be short-term corporate bond funds. Despite what I just said about corporate bond valuation being near all-time tights, corporates tend to perform fine as long as the economy keeps growing and earnings remain steady or improving. So, while there probably isn't much upside to corporate bonds, I think shorter-term investment-grade bonds will do fine in the next year or so. I don't mind if the fund has some high-yield either, but I'd try to keep it to B and BB-rated bonds. Very low quality bonds are going to the first to get killed if the cycle surprisingly turns negative. I'm not a big fan of broad high-yield funds here for that same reason. But a generalized shorter-term credit fund with a 20-25% in junk bonds could be a decent choice. 'Floating Rate' Funds Speaking of junk bonds, be aware that usually floating rate funds are mostly made up of bank loans. Effectively these are just junk bonds that float vs. London Inter-bank Offered Rate. I don't generally have a problem with bank loans, but I would feel similarly about them as I do broad junk bond funds. Spreads are priced to perfection, and if you are using bond funds as a safety allocation, I don't think this fits the bill. Don't forget what happened in the fourth quarter of 2018. At that time, markets became concerned that the Fed had hiked rates too high and some kind of economic slowdown was a risk. High-yield bond spreads moved 212 basis points wider, the biggest quarterly move since the Greece default. It isn't that hard to imagine that same kind of thing happening once the Fed starts hiking. So there's a possibility that credit spreads could blow out at the same time that general interest rates are rising. To me that makes overly aggressive credit allocations a poor way to avoid rate risk here. TIPS Most readers should know how I feel about Treasury Inflation-Protected Security, or TIPS. I've been shorting TIPS for a few weeks now, and although my position is about flat currently, I still love this trade. Inflation risk is very real, but there is also a meaningful amount of inflation already priced into TIPS. I believe that if the economy continues to grow inflation pressure will continue to build. However, if realized inflation gets to the Fed's pain point, which is probably around 2.5%, it'll start hiking. If that happens, it is very unlikely that inflation will average well over 2.5% over some longer period of time. With TIPS currently pricing in around 2.6% inflation now, there isn't much upside left for actual inflation expectations. On the other hand, if the Fed does hike to stamp out rising inflation, real yields will start to rise. Basically real yields reflect the future of Fed expectations and these effect TIPS and regular bonds in exactly the same way. That means that if the Fed reacts to inflation in the way they are promising, TIPS won't hedge a darn thing. Its all downside, no upside. Short-Term Municipals The vast majority of the time, municipals are a much better deal for tax-paying investors compared to just about any taxable bond. This is not one of those times, especially for shorter-term bonds. Right now a 5-year AAA-rated municipal yields about 0.42%, which is just over 50% of the equivalent Treasury bond. Historically the ratio between municipals and Treasuries is usually around 80%. Some of this reflect expectations for tax rates to go higher in the next few years, which is reasonable. But municipals have never historically traded right on the maximum individual tax rate. It would be very easy to imagine municipals yields backing up substantially even if all other rates remain flat. I definitely think rotating out of municipals into either a mortgage-based fund or a shorter-term corporate fund will not only earn you more after-tax yield, it will also avoid these extreme valuations in the muni market.

How to Switch to Safety With Bonds and Bond Funds

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