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Portfolio Update

There’s Still a Place for Bonds in an Income Portfolio

By Roger S. Conrad, on Aug. 22, 2017

Treasuries, municipals, corporate notes, high yield or “junk” bonds: Wherever you look in the debt market these days, you’ll find yields that are within a stone’s throw of multi-decade lows. And at the same time, the risk premium between investment grade and non-investment grade–or “junk”–bond yields is also near a low point.

It’s not that investors have suddenly lost their sense of caution about the risk of tougher credit market conditions and rising interest rates in coming years. But they have stepped up inflows into investment products that utilize passive investing strategies, such as Vanguard Target Retirement Funds.

The Vanguard funds shift money between index exchange traded funds according to an algorithm based on an investor’s projected years to retirement. As the target year approaches, investments become more conservative, i.e., more weighted toward bonds and less to stocks.

The Target Retirement 2035 Fund (VTTHX), for example, held 20 percent of its $28.9 billion in assets invested in bonds as of its most recent published figures. Nearly half of the Target Retirement 2020 Fund’s (VTWNX) $30.65 billion in assets are some variety of bonds.

It doesn’t take a lot of imagination to see how an influx of investment into a fund that size can ramp up demand for bonds and, thereby, prices. Mainly, the investment inflows to Target Retirement Funds and other passive strategy vehicles require the index ETFs they use to buy more bonds. And the result is buying momentum that’s pushed up prices for bonds in circulation, and allowed companies to issue new debt at premium prices (low coupon interest rates).

A- rated Wisconsin Energy’s 6.875 Percent Bonds of December 2095, for example, currently yield less than 4.6 percent to maturity. Investors are accepting an annual return of just 4.6 percent to lock up their money until 2095, nearly 80 years from now!

Being able to sell bonds so cheaply has been an unprecedented boon for corporations. And they’ve taken full advantage, refinancing to cut interest costs and extending maturities and raising cash to fund profitable business expansion.

That’s the stock market equivalent of a company growing its earnings 8 percent a year trading at 100 times those same profits. And unfortunately, it’s made the past few years a remarkably difficult time for investors to find yields anywhere on bonds that even approach historical norms, let alone any value in the bond market.

For example, the 12-month return for Vanguard’s Core Bond Fund (VCORX)—a key element of Target Retirement funds—is just 0.4 percent. That includes a yield of just 1.43 percent, which is actually 29 percent less than what the fund paid 12 months earlier. That doesn’t come anywhere close to funding anyone’s retirement—and it’s a high price to pay for saving a few basis points of fees by abandoning active investing.

Closed End Bond Funds: Still Some Value

Fortunately, as our table indicates, selected closed-end funds have offered both higher yields and far superior returns the past several years. The 25 listed funds represent our Capitalist Times Premium coverage universe with the most current available data.

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