Bonds are confounding investments in today’s market. There’s certainly no shortage of conservative income investors wanting to allocate a chunk of their portfolio to bond investments. The question is what bond investments to buy and what are the risks?
Rising rates is the overarching risk. When interest rates rise, bond prices fall. This leads to capital losses.
Rate-rise chatter was amplified this week. Federal Reserve Governor Jerome Powell said he sees the Fed raising the federal funds rates this September. This increase could be supplemented by an additional increase in December.
The prospect of a higher federal funds rate has investors hesitant to buy bonds. But I think opportunities exist in the right bond investments. Specifically, I see opportunity in quality intermediate and longer-maturity bonds.
Investing further out on the yield curve might seem counterintuitive. If rates rise, longer-term bonds drop in value more than shorter-term bonds. That’s certainly a concern. But intermediate and longer-term bonds offer higher income payouts than short-term bonds of equal quality.
That said, it is reasonable to think that intermediate and longer-term bonds have already priced in higher interest rates.
The yield on the 30-year U.S. Treasury bond is up 80 basis points since February. The 10-year U.S. Treasury note is up 60 basis points. Inflation remains muted. This suggests that any interest-rate moves by the Fed will be concentrated on the short end of the yield curve. Short-term rates will rise, but longer-term rates should stand pat or rise only moderately.
I particularly like the opportunities in closed-end bond funds. Unlike open-end mutual funds, closed-end funds don’t need to sell assets to meet redemptions. This advantage makes it easier for bond managers to manage the fund should a liquidity crunch arise. They don’t have to sell into a down market.
Many closed-end funds trade at a deep discount to net asset value. Many yield over 8%. The key is not to chase the high yield if it is achieved through excessive leverage. This is where a fund manager uses short-term borrowings to boost income. If short-term rates rise, these high-yield bond funds could get dinged. Quality also matters, and both funds own quality bonds.
MFS Charter Income Trust (NYSE: MCR) invests in U.S. and foreign corporate bonds. It also invests in U.S. Treasury notes and bonds and mortgage-backed securities. U.S.-based investments account for 63% of the fund.
MFS uses leverage to goose the payout. Leverage is 15.9% of the portfolio. I think this is reasonable and not excessively risky. It enables MFS to pay $0.07 per share each month, which produces an 8.4% annual yield.
MFS trades at an 11.9% discount to net asset value. The three-year average discount is 8.7%. MFS shares are on sale.
Montgomery Street Income Securities (NYSE: MTS) is the more conservative of the two. The fund invests in high-grade corporate bonds, government securities, foreign bonds, U.S. Treasurys and U.S. mortgage-backed securities. U.S. Treasury securities account for 25% of the portfolio.
Montgomery uses no leverage, yields 4.42%, and trades at an 8.6% discount to net asset value. It, too, is on sale.
I’ve been hesitant to venture into bonds and other fixed-income investments for the past three years. Times change, though, and now at least a couple of these investments look appealing.
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