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QE-Infinity has promised a certain long-term stability to bond pricing, but that doesn't mean you can forget your bond holdings entirely, notes Stephen Leeb of Leeb Income Performance.

With the FOMC debating just how long monthly bond purchases will last, we believe it may be the time to start paring down our bond holdings.

This issue, we are saying goodbye to the group’s lowest yielder, Vanguard GNMA Fund (VFIIX). Its indicated yield has steadily declined over the last five years, together with mortgage rates, and now stands at only 2.2%. The fund also isn’t without its risks.

• First, interest rate risk: as rates rise—the only direction they can go from here—the prices of fixed-income instruments (bonds) must decline. This is fully applicable to GNMA securities.
• Second, as rates go up, refinancing will decline and GNMA fund managers will likely lack the capital they would need to reinvest in more attractive, higher-coupon new issues. Sell.

Note that two pure bond funds still remain in our portfolio, PIMCO Total Return (PTTDX) and Loomis Sayles Bond (LSBRX), and both also remain recommendations. These two funds have much more flexibility concerning instruments in which they can invest.

Why is that important? While neither fund can fully counterweight the inherent risks of bond investing (i.e. interest rate risk), they can and do manage duration, credit, country, and, to some extent, they also even venture into other asset classes (in case of the Loomis Sayles fund).

Just look at the total annual performance for 2012 and the funds’ current yield. PIMCO’s current yield is 2.4%, but the fund returned 9.93% in 2012 (placing this fund in the top 14% of the intermediate-term bond category).

Loomis Sayles Bond did even better for 2012: with total return of 14.77% it’s also in the top 14% of its multi-sector bond category. The higher return and higher yield of 5.4% here indicate a higher level of risk, but owning shares in this fund are well worth those risks. We are keeping both in the portfolio, and at these levels, both funds remain buys.

What to do now: Sell Vanguard GNMA, but you can still buy PIMCO Total Return and Loomis Sayles Bond for the fixed-income portion of your portfolio.

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