CHARLESTON, W.Va. -- As many people know, interest rates are at historic lows, and have been for several years.That's great news if you want to borrow money to buy a car, or take out a home mortgage.But for retirees who count on bond income to cover the their daily living expenses, it's a whole different story.And yet, folks who own a piece of the Pimco Total Return bond fund, an anchor of many 401-k plans, earned more than 10 percent on that investment last year.How is that possible?As Ed Stike, senior vice president at RBC Wealth Management, says, it's all about relative movement of interest rates. "I think what happened in 2012 is exactly what happened in 2011 and 2010 -- interest rates finished the year below what they were they were the year before," said Stike."When yields [interest rates] go down, the value of the bond goes up. So if you bought a bond in January and held it in December, not only did you get the interest on the bond but the $100 bond is probably worth $102."Bond funds work the same way. Prices go up when interest rates fall, and they drop when interest rates rise.The general barometer for tracking bond yield is the 10-year U.S. Treasury note rate, Stike said. Last year it fell from an already anemic 1.97 percent in January to 1.78 percent in December.
"But the bonds that did well last year were corporate bonds, not only high grade but what we call lesser quality or high yield," better known as junk bonds."For example, a [junk bond] mutual fund was up 14 percent," he said. "Investors who had high-yield or junk bunds last year did even better than stocks. You had mid-teen returns."Ironically, consumer demand for higher-yielding bonds has helped drive those interest rates down, Stike said. It's simply a matter of supply and demand."What you see is investors have a truly insatiable demand for yield now. There's so much demand for yield that it drives rates down. When companies issue debt they don't have to issue it at 10 percent. They can issue it at 7 percent and people will buy it."Everyone with money in the bank -- retirees -- they're dying for yield and they have bee for the last several years. So if they see 7 percent, they go out and get it.
"What does that mean? Nothing if everything goes smoothly. The default rate for high-yield bonds has fallen below 2 percent, which is historically low."
But should the economy plunge into another recession, all bets are off. "If they're wrong, the default rate will likely soar."The other risk is rates could start rising again. If that happens, your bonds lose value."We think ... you could easily be lulled into security because you think government yields will continue to go lower," Stike said. In fact the 10-year Treasury rate has already started to creep upward."We think the best offense is a good defense. You'd better bring some credit into your portfolio and do your homework."Bond funds are a better bet for most people than individual bonds, he said. "We think most individuals don't know how to analyze credit risk, so we feel it's best to have some professional input."
Read the fine print when looking for a bond fund, Stike said. Look for the term "unconstrained," which means the fund manager has leeway to buy a wide variety of bonds instead of sticking to a narrow focus."We like to have a tactical approach. We like a manager to be unconstrained. If he is constrained, he's stuck."Old rules about shifting your investment mix toward bonds as you get older don't make sense now, Stike said, with interest rates so low."The big things now are these target-date or lifestyle funds. They automatically put you on a glide path to more bonds as you get older. We feel that's putting you in a risky situation. We don't think that takes into account today's situation."If you're 60 years old and going to overweight bonds when yields are at all-time lows and prices at all-time highs, we don't think that makes sense."That's why we like a tactical approach -- looking out three to six months, rather than automatically loading up with 60 percent bonds."Dividend-paying stocks can be a good substitute for bonds, he said. "The dividend yield right now on the S&P 500 is greater than the 10-year Treasury note. So we think it makes sense to buy dividend-paying stocks."You can buy ETFs [Exchange Traded Funds], like 'dividend aristocrats' -- companies that increased dividends every year over the past 20 years. I think with ETFs it makes 0 percent sense to own individual stocks. ETFs are very low cost. You can buy ETFs for five to 25 basis points [.05 percent to .25 percent annual fee]."It's not your grandfather's bond market," he said. "If you retired in '94 with a million dollars you could make $80,000 a year [in interest earnings]. Five months ago it was $14,000. Now it's $20,000, and what has inflation done since 1994?"It's forced people to take more risk," Stike said. "So you better be careful."Reach Jim Balow at email@example.com or 304-348-5102.