For Wall Street, the need to own bonds has always been an article of faith. But rarely if ever has the debt of corporations, governments and other entities been so popular.
The key metric is yield. A bond’s yield is essentially its annual return, i.e. what the market requires to compensate for inflation and credit risk that’s always a threat to principle and interest.
The lower a bond’s yield, the lower the perceived risks. The current 1.95 percent yield on 10-year Treasury bonds compares to the all-time low of 1.39 percent set in mid-2012. But it’s still among the lowest levels in history, and barely half what it was just two years ago.
Yields on debt of US corporations are even lower relative to historic norms. Master limited partnership Enterprise Products Partners LLP (NYSE: EPD), for example, has issued a bond maturing January 18, 2068 that currently yields just 3.69 percent to maturity.
Yield to maturity or “YTM” takes into account that all bonds are eventually paid off or “mature” at par value, which is generally $1,000. Enterprise initially sold these bonds with a yield of 7.034 percent.
Investors, however, had bid up their price to where the annual return factoring in a final payoff of $1,000 is just 3.69 percent. That’s all they’re requiring to lock up money for 55 years in a company with a barely investment grade rating from Moody’s of Baa3.
Enterprise is hardly alone in selling debt at historically high prices, i.e. historically low yields. Electric utility/unregulated power producer NextEra Energy (NYSE: NEE) has BBB-rated bonds maturing September 1, 2067 with a YTM of just 4.3 percent.
The norm for newly issued 30-year debt of BBB-rated utilities has been less than 4 percent for more than a year. Returns for bonds maturing in five years are barely 1 percent, while anything paying off sooner can be measured in cents.
Along with the record levels of corporate cash that I cited in the December 21 Mind Over Markets, there’s no more bullish catalyst for companies’ earnings here in early 2013. Low borrowing rates are not only slicing interest costs and eliminating near-term refinancing risks; they’re also enabling companies to raise capital to fund growth.
And having minimal near-term refinancing needs means companies can simply put off new bond offerings whenever selling conditions temporarily worsen. That forces the buyers of bonds—principally mutual funds—to pay up for whatever is available.
Unsafe Havens
Since the market bottomed in March 2009, stocks have far and away been the place to be. Many investors, however, haven’t participated for fear of another 2008 or worse. Those worries continue to be stoked up by a continuing political diatribe in the popular financial media, causing all too many to fall prey to the mistake of allowing those leanings to shape investment decisions.
The result is many investors have holed up in bonds as supposedly a safer alternative to stocks. And they’ve been encouraged by the fact that many popular vehicles for investing in bonds continue to pay decent yields.
PIMCO Strategic Global Government Fund (NYSE: RCS) is a former Personal Finance Income Portfolio recommendation with a stellar long-term performance record. At its current price of roughly $11.70 per unit, PIMCO yields about 8.2 percent based on its monthly dividend of 8 cents a share. And that’s not including the “special cash” distribution paid January 18 of 28.5 cents.
Considering the fund’s mission of holding only government-backed securities, PIMCO would seem at first glance to be the ultimate investment in this uncertain market: A fund holding safe bonds that boasts a yield higher than 90 percent plus of all stocks. And to be sure, investors have been rewarded with high total returns the past four years as well:
2009 38.3 percent
2010 13.2 percent
2011 23.7 percent
2012 13.4 percent
The fund is also up roughly 3.8 percent thus far in 2013. And it held the line in 2008, with a dip of just 0.16 percent.
PIMCO, however, also pays a dividend yield that’s more than twice the YTM on 55-year debt of Enterprise Products Partners. And that’s even selling at a stock market price that’s more than 21.6 percent higher than the value of its assets, or net asset value (NAV).
Open-end funds mint new shares whenever investors want to buy. They then cancel those shares when investors sell. As a result, the value of an open-end fund always reflects the current prices of its holdings. Managers buy bonds when money comes in and sell when it flows out of the fund.
The biggest advantage of closed-end funds is managers don’t have to buy when investor interest in bonds grows and prices rise. Nor do they have to sell when interest wanes, forcing prices to fall. Rather, they mint a set number of shares that trade on major exchanges, mostly the NYSE.
The biggest disadvantage for investors is the market price doesn’t necessarily match the value of the fund’s assets. And in PIMCO’s case, you’re basically paying $1.21 and change for $1 of assets.
That’s something investors have deemed worthwhile because of management’s great track record. But the premium does make it lot harder for the fund to pay out such a high yield. Clearly, they’re doing something extraordinary to make that happen.
As it turns out, they are—and despite management’s track record of correctly navigating the bond market year in year out, it’s somewhat frightening.
For one thing, PIMCO was at last count employing 50.88 percent leverage. That is, it’s borrowing against more than half the value of its holdings by a range of means, to realize a bigger gain on price moves and higher interest income.
That’s a very profitable strategy when the prices of the bonds inside are either stable or rising. On the other hand, should the prices of those bonds drop, the fund’s losses would also be magnified. And the reaction in the market would likely be greater still, owing to the fund’s large premium to NAV.
Second, PIMCO’s portfolio at last count was heavily loaded with mortgage-backed securities, many of the Fannie Mae variety. This too has been a profitable strategy, as Uncle Sam has backed their value and held interest rates low. But should either of these conditions shift, the result could be a loss of portfolio value that again will be exaggerated by the use of leverage and the fund’s lofty premium to NAV.
Ironically, I’m a lot more bullish on PIMCO Strategic Global Government than almost any other closed-end bond fund, mainly because of management’s demonstrated abilities and experience. But that makes its example all the more important for investors to take note of, particularly since so few are.
To be sure, I own individual bonds in the model Portfolio of my Utility Forecaster advisory. And Ben Shepherd and I carry a range of bond mutual funds in our Personal Finance Portfolios as well.
These are, however, among the relatively few exceptions in what’s become very much a sellers’ market for bonds. And while they offer safety in almost any market—including the possibility of rising interest rates—they’re not likely to offer the best returns in 2013, or even the fattest yields. Economic and political uncertainty aside, stocks are still the place to be as they’ve been since early 2009—at least for most of your money.
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I appreciate the status and analysis on Pimco’s RCS fund. I hold this fund in my IRA and will monitor it closely if interest rates start to rise this Spring as expected by some experts.
DCC