Is Your Bond Manager Making Risky Bets?
Over the last few days there have been a number of stories about how "bond king" Bill Gross has been wrong about the direction of interest rates. Particularly, he made a big public splash a few months ago when he announced that he was selling his US Treasury bond holdings because he thought the bonds were overvalued.
In bond-speak that means he thought that interest rates would rise and bond prices would fall. Thus, he sold his bonds before he thought the price would decline. But he has been totally wrong. Bond prices have risen as interest rates have fallen.
Mr. Gross runs one of the largest bond funds in the country called the Pimco Total Return Fund. You can go to Yahoo finance and chart the price of that bond fund over the last year and see how much it has fallen. You can then compare the price of that fund against one of the passively managed aggregate bond market ETFs, like the Vanguard Total Bond Market ETF or the iShares Barclays Aggregate Bond Market ETF. You'll see the passive approach has done better over that time frame.
- Now I'm not suggesting you use any of these funds. I'm just pointing them out for the purpose of illustrating the passive vs. active management debate.
In general, bond managers aggressively trade bonds and bet on the price movements of the bonds. And those price movements are related to interest rate movements. So in order to predict the price movement, you have to accurately predict interest rate moves. And to predict interest rate movements, you have to predict the course of the US and global economies.
As Mr. Gross' recent performance illustrates, that can be hard to do. Now, he may eventually be proven right and his bets pay off; he has a good long-term track record. But who knows? Because interest rates have basically been declining for 30 years, most active bond managers have had the wind at their backs. As rates have fallen, they've gotten not only the interest payments but some price increases as well. But now we face a situation where predicting rates is very complicated, and if you're wrong, you can lose lots of money in bonds.
If you're an individual investor, you should consider owning bonds for their interest payments and the promise of getting your money back when the bond matures. That's really how they're intended to work. If you stick with high-quality bonds, it's usually a straightforward investment. Yet many bond managers have taken what is a generally a pretty simple and safe investment and turned it into a risky play.
If your bond manager bets wrong on interest rates, you can see bigger losses in a part of your portfolio that you thought was supposed to be pretty conservative.
If you're not sure if your bond manager is active or passive, this would be a good time to find out. Generally, if your bond manager is described as a "total return" manager, the odds are the manager trades bonds. Total return generally means they're looking for the interest payments plus some return (or potential loss) from trading the price movements. But you can't simply rely on the fund name or description. You have to do your own research on the manager's strategy, or work with an advisor who can do it for you.
The point is to make sure the the type of bond manager you have is matched up with the type of risk you want to take in the bond market.
Bottom line. Betting on bond prices can take a conservative investment and turn it into a risky strategy.
Above material does not constitute investment advice and is not a complete analysis of of the issues involved. Consult your individual financial advisor prior to making any financial decisions. Past performance is no guarantee of future results.
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