Investors have been selling bonds on expectations that inflation will push up interest rates, eroding the value of fixed-income securities.
Ken Leech, who manages a $22 billion bond fund that’s ranked in the top percentile in its category over the past 10 years, says that could be a serious mistake.
“Whenever you read scare stories about higher rates, you worry about investors selling at the wrong time,” Leech said in an interview Feb. 20. Selling into declining prices can erode your capital and remove a source of income, while increasing portfolio risk.
Leech is the investment chief of Western Asset Management in Pasadena, Calif., which has about $442 billion in assets under management. He’s led the team-based management of the $22 billion Western Asset Core Plus Bond Fund WACPX, +0.17% since it was established in 1998. Morningstar has twice given teams he’s worked on the fixed-income manager of the year award.
The fund has a strong track record, which we’ll show below. And Leech has ideas of how to find attractive bonds in a rising-rate environment.
Correct calls
Last year the fund was positioned, correctly, to benefit from a flattening of the yield curve, as short- and intermediate-term rates rose and long-term rates fell. Currency exposure to the euro, in particular, helped performance, as the dollar fell.
Both investment-grade corporate bonds and high-yield bonds contributed to performance. Examples of the former were Bank of America BAC, -0.19% Wells Fargo WFC, -0.37% and Goldman Sachs GS, -0.56% Examples of the latter were Albertson’s, Whiting Petroleum WLL, -3.96% and Freeport-McMoRan FCX, +1.63%
Leech discussed the fund’s success and its strategy in the interview. Let’s first consider why bond prices fluctuate and what that might mean for you.
How to get income and create a safer portfolio
Despite the headlines and self-appointed investment gurus urging you to play bonds as you would stocks (looking to make money on market-price increases), the main reason to invest in bonds is to earn income. That is, a stream of money to be used as if it were a secondary salary.
A bond’s stated interest rate (also known as the “coupon”) is based on its face value, or par value. The bond’s market value will fluctuate in the opposite direction of interest rates. That is, when rates rise, the market value tends to fall. However, if you hold a bond until it matures, you will get your money back (barring an unlikely default for investment-grade debt) while earning interest the entire time. You won’t have to worry about its market value declining.
A bond fund’s share price (or net asset value) fluctuates every day, based on the market value of the bonds it holds. The longer the average maturity of the fund’s portfolio, the more sensitive the share price will be to interest-rate movements. This explains the headlines urging you to sell when interest rates rise. But you might still want the income. You must also keep in mind that what you would experience as an individual investor holding bonds until maturity will also be experienced by bond-fund managers. They will be paid the face value of the bonds upon maturity. So during a period of rising interest rates, as bonds mature, a fund will invest in higher-yielding bonds, and its yield will rise.
The bottom line is that if income is your objective, patience is required to keep the income stream coming over the long term, whether you hold your own bonds or shares of bond funds.
“There is an argument that fixed income can be a terrific performer when equities are very soft. That is why you need it in your portfolio,” Leech said.
Independent investment manager Cullen Roche recently explained how a mixed portfolio of bonds (or bond-fund shares) and stocks can protect you from the risk of “another 2008” and the type of value decline you would experience if you held only stocks.
Also see: Why investors shouldn’t panic over falling bond prices
An outperforming bond fund and its strategy
Morningstar has a five-star rating, its highest, for the Western Asset Core Plus Bond Fund’s Class I shares, which have performed well compared with the fund’s benchmark, the Bloomberg Barclays U.S. Aggregate index, and Morningstar’s intermediate-term bund fund category:
| Total return - 1 year, through Feb. 20 | Average annual return - 3 years | Avg. return - 5 years | Avg. return - 10 years | Avg. return - 15 years | |
| Western Asset Core Plus Bond Fund - Class I | 3.6% | 3.2% | 3.4% | 5.9% | 5.6% |
| Bloomberg Barclays U.S. Aggregate index | 0.8% | 1.3% | 1.8% | 3.8% | 3.9% |
| Morningstar’s intermediate-term bund fund category | 1.2% | 1.4% | 1.8% | 3.9% | 4.0% |
| Source: Morningstar | |||||
The fund ranked in the third percentile within Morningstar’s intermediate-term bund fund category for one year, second percentile for three and five years, top percentile for 10 years and fifth percentile for 15 years.
The fund has several share classes, some of which have sales charges.
The Western Asset Core Plus Bond Fund holds over 1,800 securities, according to Morningstar, giving investors “an enormous amount of diversification,” according to Leech. He explained that the fund had flexibility to take advantage of major changes in debt markets, including the “huge scare” in 2015, when prices of oil and other commodities dropped. He also said that non-government bonds in the U.S. were excellent values in 2016.
“In 2017, in contrast, we thought the opportunity was outside the United States,” he said.
That was for two reasons: Corporate bond spreads over Treasury bonds in the U.S. had declined, while an economic recovery enabled the fund to boost its returns through rising prices of government bonds in “peripheral” European countries, including Spain and Italy.
Looking ahead
But an even greater opportunity was emerging markets, which had the best returns last year, he said.
Looking ahead, Leech said “the opportunities in emerging markets are robust, as global markets continue to improve. That is our No. 1 opportunity.”
A number of adjustments were made to the fund late last year. The managers increased their allocation to U.S. Treasury Inflation Protected Securities (TIPS) as a hedge against accelerating inflation. They also added to the fund’s bank-loan exposure, as they deem that category more attractive than high-yield bonds.
At the same time, with 10-year U.S. Treasury notes yielding close to 3%, Leech sees incredible demand for U.S. bonds from foreign investors. That demand should maintain upward pressure on bond prices and, therefore, keep interest rates from rising too quickly.
So investors might want to rethink their concern over rising rates in 2018.