September 11, 2012
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Several actively managed bond funds have achieved significant outperformance relative to their benchmarks despite recent low interest rates. The strategies employed by these funds can and will continue to outperform without needing rates to fall further.
Many investors today wonder if near-zero interest rates make investing in bonds unwise. A number of prominent investors have been vocal about deciding to be short U.S. Treasury bonds over the last few years. These bond bears were quick to point out that the asset class has been in a 30-year bull market and that absolute rates have little room to fall.
Since the 10-year Treasury’s record-low yield of 1.38% in late July, its yields have spiked sharply. The 10-year Treasury yield rose almost 50 basis points in less than a month’s time before falling back to the mid-1.60s as of August 24.
My objective is not to dwell on short-term market fluctuations but to highlight the typical fears that reluctant bond investors face. It is not practical to time or predict interest rate movements, but it’s helpful for investors to understand that the success of various fixed-income strategies isn’t necessarily predicated on continued falling rates.
Let’s look at how three funds are positioning to outperform despite the current environment.
PIMCO’s “best ideas” fund
PIMCO’s Dynamic Income Fund (NYSE: PDI) is a relatively new closed-end fund, having had its IPO on May 24 of this year. It invests in a multitude of fixed-income asset classes. As of August 24, the fund’s net asset value (NAV) had increased 11.08% since its inception. The bulk of its outperformance has come from the non-agency mortgage-backed security (MBS) portion of the portfolio, where prices have risen between 5% and 10% over the past few months.
PDI’s holdings in the debt of financial corporations (Cantor Fitzgerald, Morgan Stanley, Lazard, and Société Générale, among others) have rallied strongly in lockstep with equities. The fund also has exposure to high-yield debt and levered loans of such companies as INEOS Finance PLC and First Data Corporation.
Because levered loans typically float to LIBOR, those securities have minimal interest rate risk – just spread and credit risk. PDI is also throwing off a lot of income with a 17.7-cent monthly dividend, or about 0.65% a month.
Although this fund may be less sensitive to interest rates than a vanilla, U.S. Treasury-heavy bond fund, it is not risk free. It faces substantial credit and spread risk. Also, unlike an open-ended mutual fund that trades at net asset value (NAV), closed-end funds can trade at a premium or a discount to their NAV.
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