Total Return Bond Investing In The Current Market Environment

2013 turned out to be a scary year for even excellent total return bond funds. For example, PTTRX (PIMCO Total Return Instl) lost -1.9% due to a well published ill bet on Treasury bonds in the mid year by its manager Bill Gross. WATFX (Western Asset Core Bond I) lost -2.1% while the general bond market index VBMFX (Vanguard Total Bond Market Index Inv) lost -2.5%. 

However, since the beginning of the year, bonds have recovered (to be precise, fixed income has been fairly strong. The following shows how our total return bond fund upgrade portfolios have done recently: 

Portfolio Performance Comparison (as of 4/21/2014):

**YTD: Year to Date

See the latest portfolio performance >>

We first introduced the general total return bond portfolios in 2010 on Advanced Strategies and then portfolios for major brokerage in June 3, 2013: Total Return Bond Fund Portfolios For Major Brokerages. So far, these portfolios have done what we expected: side stepping bond market weakness and still deliver reasonable returns: in 2013, these portfolios still delivered positive returns and in 1, 3, 5 and 10 year time frames, they all did better than PIMCO total return bond fund. 

In the following two newsletters, we discussed the difficulties and techniques for fixed income investors in current market environments: 

• September 16, 2013: Fixed Income No More?
• March 18, 2013: Are Bond Investors Doomed?

In these newsletters, we recognized the possible ending of the 20+ year bond bull market and discussed the need of a more tactical and active investing approach in this area. However, we disagreed with the popular pessimistic view and believed one can still obtain reasonable returns even in the coming years. Specifically, we stated the possibilities in the following three bond segments:

• high yield bonds: with super loose and accommodative monetary policies from the central bank, companies can obtain credits more easily. Low grade companies such as those small cap companies can finance their operations through junk bond issuing. High yield (or junk) bonds have exhibited strong and reliable momentum, as shown by our advanced portfolios such as P High Yield Bond Alpha VWEHX. This renders high yield bond funds as good candidates for a trend following strategy. 
• Long term bonds in TIPs (inflation protected bonds), Treasury and corporate bonds: long term bonds have played important roles in a permanent portfolio (see All Weather Portfolio Construction Part 1: Permanent Income Portfolio) or risk parity based all weather portfolio (see Ray Dalio’s All Weather Portfolio: A Variation of Permanent Portfolio). Both Harry Browne and David Swensen have advocated using long term bonds as an insurance for a portfolio (see, for example, David Swensen Six ETF Asset Individual Investor Plan).  Given exceptional low yields in the long term bonds, however, one has to be careful, especially in using them statically in a strategic asset allocation portfolio. We would feel more comfortable in using them in a tactical or trend following portfolio to take advange of these bonds’ strength when present. 
• International and emerging market bonds: two reasons to have these bonds as portfolio building candidates: 1). U.S. dollar weakness as the loose monetary policy adopted by the Federal Reserve bank and the U.S. government debt issue have driven U.S. dollar valuation steadily lower for the past 10 years. It is thus a good hedge to have exposure in foreign bonds that are denominated in local currencies. 2). The past decade has seen emerging market economies have risen to rival developed markets. In fact, many emerging market countries such as China, Brazil and Russia have sovereign debts that are much more sound (at least based on reported data). Emerging market debts have high yields.  We again feel investing in these bonds warrants an active or tactical approach.

The recent performance of our total return bond fund portfolios re-enforced the above views. For example, 

• Loomis Sayles Bond (LSBRX) and PIMCO Income (PONDX) have had a sizable exposure in high yield bonds recently. This has helped our portfolios to deliver better returns since last year. 
• Bill Gross in PIMCO Total Return is famous in using foreign bonds such as emerging market bonds and international bonds to boost its returns. It is also true for other PIMCO’s bond funds. 
• Doubleline total return (DLTNX) and TCW Total Return (TGMNX) have invested in agency bonds (Mortgage backed bonds) shrewdly. 
• Most total return bond funds can have exposure in long term and intermediate term bonds tactically in a period they see the economy is slowing or yield curve is flattening. 

Our position in fixed income investing remains unchanged: we see many difficulties ahead that require a more tactical approach. However, we are optimistic.  To achieve a reasonable return, we adhere to the following two principles:

• We need to have exposures in higher return segments such as high yield bonds, convertible bonds, foreign bonds and long term bonds as opportunities arise. 
• We need a systematic approach to do so. We either rely on bond managers’ momentum or bond segments’ momentum to gain the exposure (and eliminate a position). Recently, we noted that even those investors who are staunched buy and hold advocates have started to abandon ‘investing in the bond market index and forget about it’ attitude and touted more exposure in high yield bonds and emerging market bonds. Since we don’t know whether these investors have a well thought out plan (and even with that, whether such a plan is well tested and supported by historical data and intuitions), we are once again questioning the ‘wisdom’ of the crowd and ‘experts’. That only tells us to stick to our well tested and intuition backed trend following (or momentum) approach in picking a good total return bond fund (or several high performing bond segments) to invest. 

Total Return Bond Fund Upgrade or Bond Segment (ETF) Momentum?

In addition to the total return bond fund upgrade portfolios, we also proposed and kept track of several bond ETF momentum portfolios. For example, we first discussed this portfolio P Bond Funds Momentum Based on Upgrading ETF Bond Funds Monthly in a 2012 Seeking Alpha article Bond ETF Momentum Portfolio For The Prime Time. This portfolio uses momentum ranking to pick top two ETFs each month to invest from the following candidate funds: 

The following shows how this portfolio is compared with a total return bond portfolio: 

Portfolio Performance Comparison (as of 4/21/2014): 

See year by year comparison >>

This portfolio has done well (the 10 year performance might be a bit skewed because of the short history of many bond ETFs in the candidate fund list). However, it did so with much higher volatility, as can be seen in the chart as well as in the year by year comparison link. For many average investors, we prefer the total return bond fund upgrade portfolios over this more volatile ETF portfolio. However, for expert users, such a portfolio provides a starting point to explore and construct a better fixed income (related) portfolio. 

Market Overview

Stocks recovered last week.  All major risk assets (other than Gold) are now ranked higher than bonds. Investors are still showing appetite for risk assets. Given the earnings season is underway, we will stay on course and let markets decide.

For more detailed asset trend scores, please refer to 360° Market Overview.

We would like to remind our readers that markets are more precarious now than other times in the last 5 years. It is a good time and imperative to adjust to a risk level you are comfortable with right now.  However, recognizing our deficiency to predict the markets, we will stay on course. 

We again copy our position statements (from previous newsletters): 

Our position has not changed: We still maintain our cautious attitude to the recent stock market strength. Again, we have not seen any meaningful or substantial structural change in the U.S., European and emerging market economies. However, we will let markets sort this out and will try to take advantage over its irrational behavior if it is possible. 

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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