The New Era in Bonds

06/11/2008 12:00 am EST

Focus: BONDS

Jim Lowell

Senior Partner & Chief Investment Strategist, Adviser Investments

Jim Lowell, editor of Forbes ETF Advisor, says the Fed’s policy has changed and bond investors need to change their strategies to prepare for an economic recovery.

We have now shifted from a Federal Reserve that was willing to do anything to defend the economy to a Fed that’s signaled in no uncertain terms that its recent round of rate cuts are likely to be its last. That means that the rate cutting winds that had been at the already overpriced bond market’s back a year ago, leading to even higher prices, could become a headwind in the coming months.

Gone is last year’s environment of moderating interest rates, where bond fund prices ticked up on every rumor of a cut and then on every realized one; longer-term funds (like those invested in inflation-protected Treasuries or TIPs) made significant capital gains every step of the way.

As a result—and based on the gathering consensus of data that supports (at worst) a shallow recession that is already priced into both stocks and bonds—we recently shifted toward a diversification that better enables us to capitalize on the probable stabilization (the precedent for a rebound) of our economy against the backdrop of a still growing global economy which favors bonds that are economically sensitive as opposed to interest rate sensitive.

Corporate bond funds have the freedom to invest in a variety of securities, including, naturally, bonds issued by corporations, virtually all of which are at least somewhat lower in credit-quality than US government issues.

Compared to the Government funds, these corporate offerings aren’t any more susceptible to swings in interest rates, and one does get a higher yield. The real difference between these funds is in their average maturities/interest-rate risks.

iShares Lehman Aggregate Bond (NYSEArca: AGG) and the SPDR Lehman Aggregate Bond (Amex: LAG) fund track the Lehman Brothers Aggregate Bond Index, which includes basically the full spectrum of bonds (government, agency, mortgage, corporate; of varying maturities), except for junk bonds. The SPDR ETF carries an expense ratio of just 0.13%, while the iShares ETF charges almost double, or 0.24%.

While junk bond funds are the riskiest portion of the domestic bond market, they’re still less risky than stock funds. In short, any investor who can afford to take on stock market risks—and most investors with time horizons over five years should-–can afford to take on junk bond risks.

iShares iBoxx High Yield Corporate Bond (Amex: HYG) hold bonds rated below BBB (the definition of “junk”) as well as unrated bonds, some dollar-denominated foreign debt, and even a fraction in common stocks or bonds convertible into common stock. In practice, HYG has been somewhat more volatile, which does provide a higher potential for return along with a higher expense ratio of 0.5%.

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