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Bond Funds: The Worst Investment You Can Possibly Make

March 30th, 2012

At our 14th Annual Investment U Conference at the beautiful Grand Del Mar in San Diego last week, I discussed a number of attractive investment opportunities available right now. But I also warned them about one of the worst investments you can make. Take a minute now to make sure you don’t have it in your portfolio right now.

As I mentioned in a recent Investment U column, we’re at the tail end of the biggest 30-year rally in bonds the nation has ever seen. Three decades ago, Fed Chairman Paul Volcker pushed the prime rate up to 21.5% to squelch inflation. Long-term Treasury yields reached 16%. From that pinnacle, long-term yields have plummeted to 3.1% today. Bond prices have soared accordingly.

But the financial crisis is over and the economy is beginning to show a pulse. Higher inflation may be just around the curve. And as yields move up, bond prices move down. And perhaps way down.

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Just about the worst thing you can own when interest rates are moving up is a leveraged bond fund. When a fund manager borrows short term at low rates in order to buy additional long-term fixed-income investments for his fund, it’s the equivalent of buying stocks on margin. It works fine while bond prices are flat or rising. But when bond prices fall – as they will when interest rates rise – these shareholders take a shellacking. If you’re not sure whether the bond funds you own are leveraged, don’t guess. Call the funds and ask.

And if you owned a leveraged closed-end fund, don’t even call. Just get out, especially if the fund is trading at a premium to its net asset value (NAV).

Recall that closed-end funds are not like Fidelity or Vanguard mutual funds. Like ETFs, they trade on an exchange and can be bought and sold throughout the day (not simply redeemed at the closing price like open-end mutual funds).

However, closed-end funds can see their prices fluctuate well above or below their net asset values (NAV). When a fund trades above its NAV, it is said to be trading at a premium. And when it trades below the NAV, it is trading at a discount.

There is no easier (or more obvious) buy or sell signal than to buy these funds when they trade at big discounts and sell them when they go to a premium.

If those premiums are huge – as many are in the fixed-income sector right now – they are ticking time bombs that you definitely don’t want in your portfolio. Here are just a few that are particularly dangerous right now:

Fund Name Symbol Premium to Net Asset Value
Pioneer Municipal High Income (NYSEArca:MAV) +13.1%
PIMCO Municipal Income Fund (NYSEArca:PMF) +14.2%
Eaton Vance Municipal Income (NYSEArca:EVN) +14.6%
John Hancock Investors Trust (NYSEArca:JHI) +18.4%
PIMCO Corporate & Income (NYSEArca:PTY) +23.2%

And then there is the biggest stink bomb of them all: PIMCO High Income Fund (NYSEArca:PHK), currently trading at a 60.4% premium to its net asset value. Over 60%! That is completely nuts. These shareholders are clearly asleep – and overdue for a rude awakening.

Even if your closed-end funds aren’t on this list, don’t be complacent. Call your mutual fund and ask if the manager is using leverage. Or visit a free website like www.cefconnect.com and check out the relationship of your closed-end funds to their net asset values.

It may well be the most important three minutes you spend on your portfolio this year.

Good Investing,

by Alexander Green, Investment U Chief Investment Strategist


NYSE:EVN, NYSE:JHI, NYSE:MAV, NYSE:PHK, NYSE:PTY


 

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