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Investors Miss Out on Great Bond Rally

Investors Miss Out on Great Bond Rally
By Ron DeLegge
September 8, 2010

SAN DIEGO (ETFguide.com) – If there’s one thing investors are good at it’s being in the wrong place at the right time. Evidence of this reoccurring trend is readily visible in the bond market, whose bullish run continues.


As bond yields have dropped, bond prices have soared. But instead of participating in the Great Bond Rally most investors are a day late and a dollar short. Why?

Let’s analyze the reasons.

Professional Mismanagement
The 2008 Credit Crisis should’ve taught people that Wall Street is the last place they should trust when it comes to managing their valuables. Too much leverage and too much overconfidence by corporate leaders steering places like Bear Stearns, Lehman Brothers, etc. contributed directly to the meltdown. The once prized stocks and bonds of these celebrated financial institutions disintegrated.

Fearing the worst, people piled into government bond funds which turned out to be the best performing investment category in 2008. How did it turn out for them?
 
Over the past three years, Standard & Poor’s data shows an overwhelming majority of active government bond funds have fared horribly compared to brainless bond index funds and ETFs. For professionally managed long-term government bond funds, 89.22% failed to beat corresponding indexes and a whopping 93.26% of all short-term government bond funds lost compared to their matching yardsticks.

The translation is fairly simple: Since the onset of the recession and the Credit Crisis, mutual fund managers have done a lousy job in managing risk and getting performance.

Hitting a Home Run with a Lob
What if mutual fund managers and their shareholders were handed a bull market of epic proportions? Would they profit or would they mess it up? One way to know is by looking at the bullish performance of junk bonds, politely referred to as “high yield debt” in investment banking circles.

After being pummeled by around 25% in 2008, junk bonds (NYSEArca: HYG) have become one of the hottest investment categories anywhere. In 2009 they jumped by roughly 40% and so far this year they’re up another 6% to 7%.

But instead of joining the party, investors in junk bond funds have been left in the cold. Just over 80% of all professionally managed junk bond mutual funds have underperformed junk bond indexes during the past year alone and almost 95% duplicated the same embarrassing results over the past five years. Meanwhile, through thick and thin, the typical investor in an actively managed junk bond mutual fund has gotten plenty of nothing.

Going Tax Free
Municipal bonds, also known as “munis,” are debt obligations issued by states and local government to finance various projects and services for the benefit of their communities. Since the enactment of the Federal Income Tax Amendment in 1913, municipal bonds have enjoyed tax exemption from the Internal Revenue Code.

As a result, munis have become popular investments, especially among high income earners looking for tax-free income. For instance, a resident of New York City that buys a New York municipal bond receives income that is free from federal, New York City and New York state income taxes.  Good as that may sound, investors have been perfecting their mistakes by aligning their money in the wrong places.
 
Professionally managed munibond funds in the two largest states, California and New York, have performed awfully over the past five years. Standard & Poor’s found that just over 97% of all actively managed California and New York munibond funds underperformed versus S&P AMT-Free Municipal Bond Indices. To add insult to injury, most of these lousy performing actively managed munibond funds have annual expenses that are quadruple the cost of matching munibond index funds and ETFs.

The message is clear: Owning actively managed munibond funds has been and probably will continue to be a losing strategy. For a better alternative, look at low cost munibond ETFs like the iShares S&P New York Municipal Bond Fund (NYSEArca: NYF) and SPDR Nuveen Barclays Capital California Municipal Bond ETF (NYSEArca: CXA). According to ETFguide.com’s ETF database, the average expense ratio for U.S. municipal bond ETFs is 0.26% and both of the above mentioned ETFs are in that general range.

Conclusion
One argument typically used in favor of actively managed bond funds over bond index funds is that money managers can increase their exposure to cash when the market goes haywire in order to reduce market volatility and potential losses. Unfortunately, this wonderfully cute theory hasn’t worked out. Even though bond index funds and ETFs must always remain fully invested, it’s hardly proven to be a disadvantage.

The Great Bond Rally teaches us the typical bond fund investor continues to strike out. While they definitely can’t buy a hit during a bear market,  even during a massive bull market they can’t seem to win. Why? Because the masses have yet to learn what index investors already know; trust the indexes not the portfolio managers that try to beat them and fail.  

CommentsAdd Comment

Ron said on September 09, 2010
  I hear you Gary. To avoid NAV discrepencies stick with index mutual funds. I've noticed what you're taking about even w/ the aggregate bond ETFs like BND vs Vanguard total bond index mutual fund, both which follow the same index, but the latter doing it with less tracking error and other subtle nonsense.
 
 
Gary Smith said on September 09, 2010
  Ron you are changing the rules on me here by bringing up the Barclays High Yield Index. I agree completely about actively managed funds not being able to beat that index as it is an index similar, albeit not as comprehenive as the Merrill Lynch High Yield Master II Index. The junk ETFs can't beat the Barclays Index either. My whole point was that the investor returns in the junk ETFs vastly underperformed those of their actively managed open end brethen in 2009 and are slightly underperforming this year. I would never trade/invest in a junk ETF because of their propensity to trade above or below their NAV and their sometimes intraday dependence on what is occurring in the stock market. I've seen days where stocks have been routed and the junk ETFs closed down by 1%, 2%, and more, yet where the open end junk funds closed up in their NAV. If you are a small time trader trading a seven figure account you don't need the volatility associated with a junk ETF as compared to the more sedate and trend persistent open end junk funds.
 
 
Ron said on September 09, 2010
  Hi Gary,

The 2010 S&P Mid-Year Scorecard of S&P Indices vs. Active Mutual Funds shows the following:

80.27% of active high yield/junk bond funds failed to beat Barclays High Yield Index over past 1 year

94.41% of active high yield/junk bond funds failed to beat Barclays High Yield Index over past 3 years

92.68% of active high yield/junk bond funds failed to beat Barclays High Yield Index over past 5 years

Here's the link:
http://www.standardandpoors.com/indices/spiva/en/us

This is damning statistical evidence in favor of indexing even in the strange universe of junk bonds.

The discrepency between the share price and NAV for junk bond ETFs you cited is well-taken, but it doesn't disprove the S&P data. It just shows that ETF managers, due to extreme circumstances, haven't done well of keeping NAV closely tied to share prices.
 
 
Gary Smith said on September 08, 2010
  >>>Hi Gary, What's the data source for your assertions? S&P data doesn't agree with your numbers. Junk bond ETFs have handedly beaten active junk bond funds over past 1, 3 and 5 years. See 2010 S&P Active vs. Indexes Scorecard.<<<<

Hi Ron, Morningstar among a few others. These ETFs haven't even been around five years so not sure what S&P could be showing for five years. Also, you or they may be confusing the NAV returns vs. the market returns for these ETFs. HYG in 2009 returned 28.86% to investors while its NAV return was 40.74%. JNK had a 37.65% return while its NAV return was 50.46%. The average return for the universe of open end actively managed junk funds was 45.55%. But there were many with returns in excess of 60% and higher, especially those that kept a small portion of their portfolios in common stocks. The return in 2009 for the Merrill Lynch High Yield Master II Index, the proxy for junk bonds, was 57.4%. It always surpasses the open end junk funds in bull markets because its a comprehensive index of some 2000 issues that includes the entire spectrum of junk. Some of these issues, the junkiest of junk and issues that are near default, are issues most fund managers wouldn't touch. By the way, the reason there was such a huge discrepancy in 2009 between the ETFs' NAV and market returns was what transpired in the last two weeks of 2008. Then as a result of what came out of the Fed meeting in mid December, the ETFs went to historic premimums above their NAV. Those premiums got adjusted back to more normal levels during the first month of 2009. In other words, during those last two weeks in December 2008, the ETFs' trounced the open end funds as they soared way above their NAV. As an aside, the Merrill Lynch Index made an all time record high today as it has done many times in 2010. This index, the H0a0 (that's the letter H but the number 0) is one of the few total return indexes where the dividends are accounted for on a daily basis. The charts of the ETFs and the open end funds do not account for dividends and you don't get the whole picture of what is actually going on in junk since historically, all of the returns from junk bonds come from their dividends, not their price or NAV. For example, in looking at a long term chart of VWEHX, the Vanguard High Yield Fund, (not one of my favorites by the way) it would appear to be in a long term downtrend since it went public at $10 in late 1979 and is now at 5.61. So its NAV has been cut almost in half yet in reality investors who bought at $10 would have multiplied their original investment many fold (because of the compounding of reinvested dividends each month) Sorry for the lengthy reply but junk bonds have always been my one true love in the financial arena because of their perisitency of trend combined with their lack of volatility. They either go straight up or staight down and when they are in a bull cycle, such as the historic one we have been in since December of 2008, you can trade/invest in them with every ounce of your liquid net worth.
 
 
BillGross said on September 08, 2010
  Hey what about me? I'm the PIMCO bond king. Why did you forget about me? My net worth is $1-$2 billion. I help people to beat the market. They believe in me. They interview me on Bloomberg and CNBC too. Even without a mustache, I'm the envy of bond fund managers. My mansion overlooks the Pacific Ocean. BTW, the word "Pacific" also represents the "P" in PIMCO. Did I forget to mention that my net worth is $1-3 billion? I like the threaten the U.S. government that if they remove taxpayer guarantees from mortgage back bonds that I'll stop buying them. It's fun having this much power, you should try it out sometime.
 
 
Ron said on September 08, 2010
  Hi Gary, What's the data source for your assertions? S&P data doesn't agree with your numbers. Junk bond ETFs have handedly beaten active junk bond funds over past 1, 3 and 5 years. See 2010 S&P Active vs. Indexes Scorecard.
 
 
Gary Smith said on September 08, 2010
  The junk bond ETFs - HYG, JNK, and PHB -vastly underperformed the actively managed open end junk bond funds in 2009 and are underperforming again, albeit slightly, in 2010.
 
 
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