This week Goldman Sachs forecast that 10-year Treasury yields would reach 3% by the end of this year and 4% by 2016. Of course, Goldman doesn’t have a crystal ball, and neither do we. But the bloom is clearly off the rose. Ben Bernanke’s announcement last month that the Fed intends to end its $85 billion a month bond-buying program by the middle of next year has turned the $11.9 trillion U.S. Treasury bond market upside down. The 10-year yield has soared from 1.76% at the end of 2012 to a recent high of 2.75%.
So while Goldman may not have any magical soothsaying powers, it is almost certainly right to warn investors off 10-year Treasurys. The reason has nothing to do with economic forecasting or market timing. Rather it has everything to do with the Fed putting the world on notice that – while its future moves will be “data-dependent” – it expects to stop holding rates artificially low.
What’s an Income Investor to Do?
Let’s take a look at a few alternatives, the first being short-term bonds. When you own a short-term bond, interest rates may rise and the price may come down a bit, but you’ll get your money back in a couple of years to reinvest at higher rates anyway. So while the market price of your securities will decline temporarily, you’re OK just sitting on your hands.
If you’re a small investor who doesn’t have enough capital to buy individual bonds and still diversify, consider an exchange-traded fund like the Vanguard Short Term Corporate Bond ETF (NASDAQ:VCSH).
This fund – which sports Vanguard’s typical ultra-low expense ratio (.12%) – tracks the performance of the Barclays U.S. 1-5 Year Corporate Bond Index. It invests in U.S. dollar-denominated, investment-grade, fixed-rate bonds issued primarily by utilities and industrial and financial companies. The current yield is 2%. Dividends are paid monthly.
Of course, bond funds offer you diversification and convenience, but, unlike bonds themselves, they do not offer to return your principal. Well, none of them did until defined-maturity ETFs debuted several months ago.
Now, for instance, you can buy the Claymore Exchange-Traded Fund Trust (NYSEARCA:BSJI) – which owns lower-quality bonds than VCSH – enjoy a 4% annual yield, and get your principal back when the bond matures in five years. (If any holdings default, of course, your final value will be impacted. There are no free lunches in the bond market.)
You’ve Been Warned
Be careful with the hot income investment of the moment, loan participation funds. These funds own collateralized, adjustable-rate loans to large corporations. (The rates are usually adjusted every 90 days.) Brokers often tout them as the ideal way to play a higher interest rate scenario.
However, these funds hold unrated securities so they tend to be volatile and risky, especially the leveraged, closed-end ones like ING Prime Rate Trust(NYSE:PPR). That fund has lost more than 10% of its share price since late April and more than third of it over the last decade.
Somewhat safer – and lower-yielding – is an open-end loan participation fund like the Neuberger Berman Floating Rate Income Fund Class A (MUTF:NFIAX). However, funds like these should never be more than a small part of a diversified income portfolio.
With a bear market in bonds underway, investors are about to learn two important lessons. The first is that past results really don’t guarantee future performance. And if you want to be safe, you have to do the same thing in the bond market that you do in the stock market: spread it around.