This post originally appeared on Forbes.com.
Bond investors are faced with a rude development: total returns – that is, the combination of income and price movement – are now negative for the year (junk bonds aside). Who even remembers the last time that was true?
Perhaps we’re not really seeing the end of a 30-year bond rally. Even if not, however, there’s simply no way bonds can maintain the run of the last decade, when rising prices generated by falling rates delivered something like 80% of fixed income returns. Those days, mathematically, have to be over.
Maybe the pendulum will get stuck here, at the lowest interest rates in living memory. But odds are that, somewhere right around these levels, it will start swinging back. Then, those gains investors have enjoyed over the past many years will reverse out, too; and bond values will fall precipitously. The “safe, non-volatile” element of the standard 60/40 portfolio will cease to be either.
Bond investors need a foxhole. Here’s one: long/short credit mutual funds. How do these work? They buy some fixed income securities and simultaneously sell others short. So long as the long positions do relatively better than the shorts, the fund will produce gains even if rates rise. As you see, it’s the same idea as classic equity long/short funds, but applied in the fixed income world. Many of these funds are designed to have “zero duration risk”: that is, to be completely indifferent to movements in overall interest rates.
The approach is sound, and many long/short credit mangers have done much better than the big bond ETFs and mutual funds of late. To cite just one specific example, the Blackrock Global Long/Short Credit mutual fund, BCGAX, is up around 1.5% this year, while the famous PIMCO Total Return Fund is down about the same amount.
And if the new trend holds, that’s just the start. Of course, if bonds do find a way to stage another strong rally from here, a long/short approach will underperform—just as it does in the analogous equity strategy, when stocks are on a tear. But it’s hard to see that happening absent a truly nasty deflationary cycle.
Whether you’re up for this particular strategy or not, it is vital for bond investors to appreciate how much interest rate risk is out there right now: rates are so low that any upward push will have an outsized, negative impact on bond values. To protect yourself, you can move into strategies and assets that have one or more of these characteristics: payouts tied directly to rising rates (like leveraged loans); the ability to increase yield over time for other reasons (like MLPs); relatively short durations (less than 3 years); those that amortize over the life (like peer to peer lending); and those that sport current yields high enough to absorb some losses but still generate total positive returns (like Cat bonds).
Unfortunately, many securities that do pay higher current coupons, like junk bonds and dividend-paying stocks, have already seen major buying and hardly look like bargains here. Other alternatives can, however, be attractive— aside from the ones already mentioned, you can look at royalty trusts, specialty and asset-backed finance, and even income producing real assets like farmland and timber. (A complete catalogue of income options is described in my new book, The Alternative Answer).
But the recommended foxhole of the day is long/short credit mutual funds. As usual, make sure the annual expense ratios are reasonable, and also watch out for stiff up-front sales loads, which, in this rate environment, can eat up a big chunk of your returns.