Fixed Income Review
Amid the interest rate hikes and economic too hot and then too cold worries in 2018, bonds, similar to stocks, went through a volatile year. Fortunately, for most of them, they came out without much damage.
In the following, we first review how well our total return bond fund portfolios did last year and then discuss some issues in fixed income investing.
Total return bond fund portfolios did ok
Our portfolios did ok last year, closely matched (slightly underperformed) total bond market index fund:
|Ticker/Portfolio Name||2018||3Yr AR||5Yr AR||10Yr AR|
|Schwab Total Return Bond||-0.8%||4.6%||3.7%||7.8%|
|Fidelity Total Return Bond||-0.8%||3.6%||3.8%||7.4%|
|TDAmeritrade Total Return Bond||0.6%||4.7%||3.5%||7.1%|
|FolioInvesting Total Return Bond||-0.8%||4.6%||3.7%||7.8%|
|Etrade Total Return Bond||-0.8%||4.6%||3.7%||7.9%|
|Merrill Edge Total Return Bond||-0.8%||3.4%||3.5%||8.7%|
|PTTRX (PIMCO Total Return Instl)||-0.3%||2.6%||2.4%||4.7%|
|VBMFX (Vanguard Total Bond Market Index Inv)||-0.4%||1.5%||2.0%||3.3%|
The slight outperformance by VBMFX (and PTTRX) was mostly attributed to the rally in late 2018 — after October when investors suddenly started to abandon stocks and favored bonds.
Looking closely at the individual total return bond funds in 2018:
|Fund Name||2018||3Yr AR||5Yr AR||10Yr AR|
|PBDDX (PIMCO Investment Grade Corp Bd D)||-2.5%||4.4%||4.0%||7.0%|
|PONAX (PIMCO Income A)||-2%||5.6%||4.8%||9.3%|
|PDBZX (Prudential Total Return Bond Z)||-1%||3.4%||3.4%||6.3%|
|DLTNX (DoubleLine Total Return Bond N)||1.8%||2.1%||2.7%|
|WABRX (Western Asset Core Bond R)||-1.2%||2.3%||2.6%|
|TGMNX (TCW Total Return Bond N)||0.7%||1.3%||2.0%||5.5%|
|MWTRX (Metropolitan West Total Return Bond M)||0.3%||1.8%||2.1%||5.6%|
|LSBRX (Loomis Sayles Bond Retail)||-3.5%||5.4%||1.8%||7.7%|
|PTTRX (PIMCO Total Return Instl)||-0.4%||2.6%||2.4%||4.7%|
|VBMFX (Vanguard Total Bond Market Index Inv)||-0.3%||1.5%||2.0%||3.3%|
A few observations:
- DoubleLine fund was at the top place, followed by TCW fund. Both overweighted in mortgage back securities.
- Corporate bond focused funds like PBDDX, PONAX and LSBRX (which had a sizable exposure in high yield bonds) did the worst as investors started to worry about corporate credit risk last year. We will discuss this issue in more details shortly.
Total bond index fund VBMFX has sizable investments in government securities: based on Morningstar, at the end of last year, it has the following exposures:
|Government securities (Treasuries, Agency bonds)||47%|
|Mortgage back securities||25%|
Government bonds and mortgage back securities performed strongly in the last quarter of 2018 as markets went into a risk off mode. This helped to boost VBMFX’s return.
The major issues for fixed income markets
As the Federal Reserve has indicated that it’s willing to be accommodative for its ongoing interest rate hikes (which implies that it’s very likely it will slow down the pace), bond markets recovered somewhat since the last Christmas. However, we want to point out/summarize the following key issues for bond markets:
- US inflation is close to the Federal Reserve’s comfort zone 1.9% vs. Fed’s target 2% rate. Thus, inflation pressure is subdue for now.
- Federal government debt/GDP ratio is historically high: courtesy of DoubleLine:
This translates to an extreme burden for the Federal government just to service the debts:
- Corporates are highly leveraged (in debt): again courtesy of DoubleLine:
What’s worse, many investment grade corporate bonds are now rapidly downgraded. If economy further slows down, it’s likely these investment grade bonds can suddenly become junk rated bonds. This will dramatically affect corporate debt markets and increase borrowing cost (higher interest rates).
To summarize, in the current bond market condition, we believe it’s important to adopt a tactical/dynamic strategy to invest as the twin issues mentioned above are likely to make fixed income investing much harder in the coming years. On the other hand, a volatile market will eventually present better opportunities.
Stocks went through a fast and furious recovery since the New Year. However it was stalled last week. For now, reports on earnings slowdown have surfaced here and there. Based on Factset, as of last Friday, 22% of the companies in the S&P 500 had reported actual results for Q4 last year. So far, the blended earnings growth was 10.9%, lower than the expected 12.2% analysts made on December 31, 2018. Analysts are now predicting a single digit 6.3% earnings growth in 2019. We suspect that if more companies are reporting earnings slowdown, the pendulum will begin to swing harder to the down side and the earnings growth rate might come down further. On the other hand, investors are pinning their hope to a possible trade tariff resolution with China and the Federal Reserve’s easy monetary policy again. Regardless, the current stock and bond hefty valuation and the long extended bull market should serve as caution.
We reiterate that staying the course and managing risk accordingly.
In terms of investments, even after the recent retreat, U.S. stock valuation is still at a historically high level and a bigger correction is still waiting to happen. It is thus not a good time to take excessive risk. However, we remain optimistic about U.S. economy in the long term and believe much better investment opportunities will arise in the future.
We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.
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–Thanks to those who have already contributed — we appreciate it.
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