More Top Managers Batten the Hatches

Last week, you read about big stock experts reflexively hedging their bets after the Dow's record high. Now, it's time for caution from gurus in another, slightly more expected asset class, writes MoneyShow's Howard R. Gold, also of The Independent Agenda.

Are you one of the millions of Americans who poured their money into bonds over the past five years, and now are nervous that rates will rise? Well, you’ve got company—the managers of the very funds in which you’ve invested.

Two managers of leading bond funds I spoke with have moved to protect their shareholders from what they view as a gathering storm. They have shortened maturities, lightened up on some overpriced sectors, and have gone far afield—outside the US—for decent yields with lower risk.

The problem, of course, is a three-decade-long rally in the bond markets, which has driven rates way down, combined with a Federal Reserve that has gone way beyond its usual rate-cutting toolbox by adding more than $2 trillion to its balance sheet. That helped push the ten-year Treasury note to its lowest yield ever—1.38% last July.

But while stocks have rallied, bond prices slipped and yields (which move in the opposite direction of prices) rose. On Wednesday, the ten-year yielded 2.02%, a big move from the lows.

And there may be many more rate increases to come.

“We’re at the end of a long-term run…,” said Thomas Carney, manager of the Weitz Short-Intermediate Income Investor Fund (WSHNX), which has $1.45 billion in assets. “If this is a baseball game, we’re in extra innings.”

And Matthew Eagan, who co-manages the giant $22.7 billion Loomis Sayles Bond Fund (LSBRX) along with the legendary Dan Fuss, told me: “We see us entering a period where rates are going to rise on a secular basis"—meaning a long-term change.

And although it probably won’t look like Apocalypse Soon, Eagan sees a steady drip, drip, drip of misery ahead for bond investors. “Nobody knows for sure, but my guess is it will be many, many years of rising rates,” he told me.

That’s very bad news for people who loaded up on bonds without realizing they can actually lose money when rates rise.

Some bonds are more vulnerable to rate increases than others. That’s why I called Treasuries, Treasury Inflation Protected Securities, and high-yield bonds the three most overvalued assets in this column last September.

• Read Howard’s take on the three most overvalued assets on MoneyShow.com.

Neither Carney nor Eagan is a big fan of Treasuries now. Investors have been losing money in Treasuries since July, Eagan told me. “These are bonds that are very sensitive to interest rate risk,” he said.

He’s even less enthusiastic about TIPs, Treasury securities that embed investors’ expectations of future inflation.

“If inflation is stable and Treasury yields go up, you lose,” he said. “If you give it enough time, you’ll lose all your purchasing power.”

• Read how rising interest rates could affect the budget plans of the president, Senate Democrats, and Paul Ryan at The Independent Agenda.

That leaves us with corporate bonds, whose yields also are—are you tired of hearing this?—coming off record lows after companies rushed to issue debt at historically cheap prices.

NEXT: The Most Vulnerable Bonds

The most vulnerable part of the corporate market are high-yield bonds, an investor favorite over the last couple of years. But their spreads over Treasuries’ yields are way below average, prompting high-yield maven Martin Fridson to call them “extremely overvalued.”

“The case for substantial price deterioration is supported by the currently rich valuation of high-yield bonds,” Fridson wrote late in 2012. He said that in markets like this one, high-yields’ return trailed Treasuries by two percentage points a year. Yikes.

And Loomis Sayles’ Dan Fuss told Bloomberg last December: "High yield is as overbought as I have ever seen it; this is absolutely, from a valuation point, ridiculous."

His co-manager Matt Eagan is a bit more circumspect. He says defaults in that sector have picked up as we enter “an old-fashioned credit cycle.”

And Tom Carney said some issuing companies are starting to leverage up again, a sign that “the ingredients for the next credit crackup are forming,” as he wrote in the fund’s recent shareholder report.

“Given how low spreads have come and the potential risk in some of the new issues of high-yield bonds, [investors] really should be thinking about capital preservation,” he told me. That’s why his fund has underweighted high-yield bonds, while cutting overall maturity and duration—a measure of interest-rate sensitivity.

The Loomis Sayles team has done the same, though their fund tends to hold longer-dated paper. They also have diversified into government bonds issued by Canada (which recently comprised 14% of holdings), Australia, New Zealand, and Norway—all “high-quality instruments [that] offer liquidity” without the problems of “debt monetization and quantitative easing” Eagan thinks bonds issued in the dollar, pound, euro, and yen have.

So, what should you do? If you didn’t start lightening up last fall, now is a good time to start.

• Read Howard’s analysis of what you should do with your money now in MoneyShow.com

I wouldn’t panic, but over the next few months, I would take money gradually out of Treasuries, TIPs, and high-yield bonds or funds that hold too many of them. Instead, put those funds into a combination of low- and intermediate-term ETFs like Vanguard Short-Term Bond ETF (BSV) and Vanguard Intermediate-Term Bond ETF (BIV).

And though I don’t usually recommend actively managed funds, I think adept, experienced bond managers can add value in a market like this. The Weitz and Loomis Sayles funds complement each other nicely, and you might consider putting some of your fixed-income money into them.

Bonds have been a magnificent investment. But nothing lasts forever, and successful investors know they have to change with the times. That means lightening up on Treasuries, TIPs, and high-yield bonds and shortening your bond portfolio’s maturity.

Now would be a good time to start, if you haven’t already.