Bond Trio for High Yields

10/21/2005 12:00 am EST

Focus:

Carla Pasternak

Editor, The Income Investor

"Mortgage-backed securities, foreign bonds, and high-yield bonds are some of the most attractive investments in today's low interest rate environment," notes Carla Pasternak in High Yield Investing. Here, she looks at a trio of bond bets offering yields of 7% or more.

"Of course, chasing higher yields does involve some risk. However, these bond ideas aren't as sensitive to interest rate moves as your average longer-term, higher-quality bond or bond fund. Instead, if you're willing to take a little risk on the credit side, these bond funds can boost yields and help diversify the interest-rate risk in your other portfolio. We emphasize that bond income is taxed at your ordinary income tax rate. Thus, the best place for these funds is in a Roth IRA or other tax-advantaged account. Here are three favorites:

"Run by the nation's largest bond manager, Pimco Commercial Mortgage Securities (PCM NYSE) invests in mortgage loans on commercial real estate properties like office buildings, shopping malls, apartments, and nursing homes. Top holdings include mortgage securities issued by giant mortgage financers Fannie Mae, GMAC, and Chase Commercial. PCM holds bonds that carry a short-term duration of less than four years, making them less sensitive to interest rate changes. With an average rating of Ba, the portfolio has a fairly low risk of default.

"Formed in 1993, this fund has delivered double-digit returns each year for over a decade. With a five-year annual average return of +13%, PCM has nearly doubled the performance of the benchmark Lehman Aggregate Bond Index. Like most close-end funds, PCM leverages (borrows on) about a third of its portfolio value in an effort to boost its returns. The fund also uses derivatives to profit from changes in interest rates. With debt just 4.4% of total capitalization, the fund also has a great deal of flexibility to finance new projects.

"PCM has paid monthly dividends of nine cents a share every month since 1995. At current prices, it yields a mouth-watering 8.1%. Given its impeccable dividend track record in periods of both rising and falling interest rates, future payouts seem assured. The fund also offers a dividend reinvestment plan. This enables existing investors to reinvest dividends and capital gains distributions for additional shares without incurring brokerage fees. Thanks to strong demand from yield-hungry investors for mortgage-backed securities, PCM is now selling at a 12% premium to its asset value and yields 8.1%. In the past few weeks, the shares have backed off from their highs and now appear to be bottoming.

"Morgan Stanley Emerging Markets Debt Fund (MSD NYSE) has a stake in some of the world's fastest growing and highest yielding markets. More than half its portfolio is invested in bonds from the oil-rich economies of Mexico, Russia, and Brazil. Most of the bonds are issued by the government or quasi-government organizations. The fund's portfolio contains just 70 holdings with an average credit quality of BB, which is just below investment grade and relatively safe. While Mexican and Brazilian government bonds are still considered sub-investment grade, Russian bonds were upgraded to investment quality by credit rating agency Moody's in 2003.

"Since its inception in 1993, the fund has delivered above-average returns. Its ten-year average annual return of +15% places it in the top three of its fund category. The fund's strategy is to focus on a small number of select bond issues with the most promising risk/reward profiles. The only downside to this strategy is that it exposes the fund to some country-specific risks. But it also means that just a few good decisions could lead to substantial upside. Along those lines, the fund's decade-long track record bodes well for the future.

"The fund recently boosted its quarterly dividend +10% to 20 cents a share. That was the second hike in two years, giving the fund a robust three-year dividend growth rate of +10%. The latest increase gives the shares a healthy 7.7% dividend yield. Trading at a 3% discount to the fund's asset value, shares of MSD are now attractively priced. That means you can buy a dollar's worth of assets for 97 cents. It also means expectations of higher rates in the US and other factors have likely been baked into the fund's share price. A steady +16% five-year average return beats many other securities by a long shot. And considering the shares are selling at less than six times earnings, I believe they are attractively priced.

"For a high-yield fund, Vanguard High-Yield Corporate (VWEHX) steers an usually safe course. More than half its holdings are rated one notch below investment grade or better, including 10% of investment-grade quality. Half of these higher-quality bonds sport the safest "Triple A" grade from ratings agencies Moody's and/or Standard & Poor's. With about 400 issues from a dozen industries, the fund's diversity also helps offset company-specific and industry-specific risks. Nearly half the portfolio is invested in safer, non-cyclical industries such as consumer staples and utilities. These types of holdings tend to perform well throughout both good times and bad.

"Given its relatively conservative portfolio, the fund's performance has been steady through periods of rising and falling interest rates. Since its inception in late 1978, the fund has delivered total returns (including share price gains and dividends) of over +9% a year. Shorter-term returns over five- or ten-year periods are about on par with the benchmark Lehman High Yield Index, but in the past few years the fund's high-quality portfolio has under-performed its riskier peers.

"The fund has been doling out dividends every month for the past 15 years. The fund is now yielding 7.1%. Its very cheap 0.22% expense ratio, the lowest for high-yield bond funds, takes a smaller bite out of returns. The fund's more conservative approach means it tends to lag its peers when junk funds rally. Thanks to a buoyant economy and low interest rates, junk bonds were one of the top-performing fixed income assets over the past three years. But if interest rates rise and the economy falters, as many analysts are predicting, junk bonds may suffer higher defaults. That's when a higher-quality fund like VWEHX could shine."

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