Dodging the Bond-Fund Bubble

10/26/2010 12:00 pm EST

Focus: BONDS

Marilyn Cohen

President & CEO, Envision Capital Management, Inc.

Marilyn Cohen, editor of the Forbes Tax-Advantaged Investor, warns investors about the mania for bond funds and suggests ways to lower risk by switching into individual bonds.

So, a fool repeats his folly. How else can you rationalize investors paying premiums—and, in many cases, ginormous premiums—over the net asset values of numerous closed-end funds?

Care to buy the Pimco High Income Fund (NYSE: PHK) at a 40% premium? How about the Eaton Vance Municipal Bond (Amex: EIV) closed-end fund at a 10% premium? Perhaps the Pioneer High Income Trust (NYSE: PHT) at a 20% premium would appeal to you? The list of funds trading at a premium over their net asset values is huge.

Are these investors that keep piling into open-end, closed-end and exchange traded funds insane? Or are they just off their meds?

Over-investing in the same bond funds the masses are tripping over themselves to buy is getting beyond reasonable limits. Are Yogi Berra and I the only ones who believe this is déjà vu all over again?

It feels like the 1993 bond mania. It feels like the technology pile-on in early 2000. It feels like the real estate frenzy that ran from 2002 through 2006. Investors are foaming at their bond-fund mouths.

I know that many subscribers are still knee-deep in bond funds. Don’t think I’m telling you to jump off the train and into cash. Instead, peel off bond fund pieces and trade them for individual bonds that lock in your yield.

If rates stay this limbo low (as has Japan’s 20-year dry spell), you’ll earn a more predictable income stream with individual securities than with funds.

When we manage bond money, we could buy bond funds of all types—I just think their time has passed. The leveraged closed end funds are having performance that is stupendous—until it isn’t.

We have a pecking order for rebalancing new accounts that come to us loaded with funds, individual positions, and cash. Here’s what we do:

  1. Deploy the cash into individual bonds
  2. Sift through all individual bond issues. Study their balance sheets, debt distribution and material events for munis. For corporate bonds, look up their earnings history, interest coverage, and debt distribution. Prioritize which positions to sell.
  3. Sell and replace individual bond issues with better quality positions
  4. Peel off bond fund positions and buy individual bonds with the proceeds
  5. Keep repeating Step 4 until all the bond funds are sold and the proceeds are redeployed to individual bonds.
A really great way to “use” bond funds, particularly taxable funds, is to study their top 20 holdings.

For example, Loomis Sayles Bond (LSBRX) fund already had several of our recommendations in the fund as of August 31st: Ford Motor Credit, SLM Corp. and the Nabors Industries 6.15% due February 15, 2018. Use the top 20 holdings from various bond funds as an idea list. Do the homework and see if any fit your parameters to put into your portfolio.

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