Bond guru Bill Gross has made his negative call on bonds clear: The bear market in fixed income has begun. As the era of quantitative easing winds down and interest rates go up, Gross has told investors not to panic, but to expect a “mild” bear market with returns of zero to 1 percent at best.
With yields on the 10-year treasury headed toward 3 percent and touching a four-year high on Wednesday, bondholders will get the income from the yield, but they’ll lose about three points in terms of price. “So they’ll get nothing,” Gross said in a recent interview with CNBC. Expectations for as many as four Fed rate hikes this year have been rising, and several Wall Street firms believe 10-year yields will be above 3 percent by year-end 2018.
Currently, Gross holds no exposure to U.S. treasury bonds — in fact, his Janus Henderson Global Unconstrained Bond Fund currently discloses a slight negative exposure to the “U.S. treasury and related sector.”
For many investors, especially those in or close to retirement, you can’t just exit bonds.
Gross can’t just get out of bonds, either. And he can’t just sit in cash — which was as high as 16 percent of the fund at year-end 2017. It’s now down to under 5 percent cash, based on Jan. 31, 2018, portfolio disclosures.
But as manager of an unconstrained bond fund, he isn’t limited in the fixed-income set he can pursue. Unconstrained bond fund managers can typically invest anywhere they’d like — hence, the term unconstrained.
Now he owns investment-grade and high-yield U.S. fixed income, non-U.S. corporates — his biggest holding outside of the United States is the Netherlands — and non-U.S. governments, including Argentinian government debt, according to the fund’s most recent portfolio disclosures.
Year-to-date there are only five categories of bond mutual funds that have been able to generate positive performance, according to Morningstar data through Feb. 21: emerging markets bonds denominated in local currency, world bond funds, bank loan funds, ultrashort bond funds and nontraditional bond funds, such as unconstrained portfolios. World bond funds have outperformed nontraditional bond funds.
The second most popular bond ETF so far in 2018 is the Vanguard International Bond ETF (BNDX), one of only five ETFs to capture more than $1 billion in new money from investors. Roughly 20 percent of the ETF is in bonds that mature in three years or less.
Among the top 10 bond exchange-traded products ranked by year-to-date performance, only one is a U.S. bond bet, and it is shorting U.S. treasury bonds: the Barclays Inverse US Treasury Aggregate ETN (TAPR), which has returned 26 percent betting against the U.S. bond market. But investors are taking a lot more risk to generate bond returns, and not only using inverse products. The next five top-performing bond ETFs are either China bond or emerging markets bond ETFs: DSUM, CBON, KCNY, LEMB, EMLC, with year-to-date returns between 3.5 percent and 5 percent.
Steven Podnos, CFP, and founder of Wealth Care, a Cocoa Beach, Florida-based financial advisory firm, isn’t surprised that the bond king has assets outside of the United States. He’s been buying international bonds for his clients for years and says that now’s a good time to have foreign fixed-income exposure.
“In America we have rising interest rates and the potential for rising inflation, both of which are not good for domestic fixed income,” he said. “Plus, foreign bonds in general are not necessarily going to move in the same direction as domestic bonds.”
Gross’ allocation to non-U.S. bonds is still small considering that the 25 percent of world’s total market capitalization is weighted to foreign fixed income.
Podnos prefers owning actively managed bond funds rather than choosing bonds himself, which can be difficult to do for most investors. He owns three funds that hold foreign bonds, but only one, the PIMCO Income Fund Institutional Class (PIMIX), is a pure bond fund. It holds 76 percent of its assets in the United States, according to Morningstar, but the rest in places like Brazil, the U.K., Denmark and the Netherlands. About 10 percent of its assets are non-U.S. government debt.
Keith Finkelstein, founder of Cape Coral, Florida-based MarketStrats, is also a believer in international bonds. He holds about 10 percent of his fixed-income allocation in non-U.S. debt, mostly through two ETFs — the iShares Core International Aggregate Bond ETF (IAGG) and the iShares J.P. Morgan USD Emerging Market Bond ETF (EMB). But these portfolios are primarily betting on overseas sovereign bonds. At 12 percent, IAGG’s top holding is Japanese government bonds, while EMB’s top holding, with 4 percent of assets, is Argentinian governments.
Finkelstein likes holding foreign bonds for the additional yield, the lack of correlation to American bonds and the fact that U.S. bond prices will likely fall as treasury yields rise.
“It’s supposed to be a pick-me-up,” Finkelstein said. “A lot of emerging market bonds are kicking off 5 percent yields.”
Gross is still primarily allocated to the U.S. bond market — 39 percent investment-grade corporate debt and 23 percent high-yield. But he warned investors at year-end that he views “the current environment with caution, especially with valuations in both Treasurys and corporate credit markets residing at what we consider to be rich levels.”
Gross went on to say, “We believe that higher-yielding corporate credits with durations under three years represent an attractive source of income that is often overlooked by the market.”
He has been pursuing that with a more global tilt since the end of 2017. At year-end the fund’s exposure to U.S. bonds was roughly 87 percent, higher than the category average of 76 percent, according to Morningstar. But now that’s down to 70 percent, according to updated portfolio holdings on the Janus fund website, as of Jan. 31.
A Janus Henderson Investors spokesman said Gross declined to comment.
The Netherlands is the Janus fund’s second-largest country weight after the United States. As of Dec. 31, 2017, Gross had 5.18 percent of his assets in Dutch-based companies, well above the category average of 1.25 percent, according to Morningstar, and similar to the weighting Dutch bonds receive in the Vanguard International Bond ETF — but that ETF invests in both corporate and sovereign bonds.
The Netherlands is a good example of a healthy bond market that is easy to overlook.
Sovereign debt experts say the country, and many of the companies based there, are solid. In fact, it’s one of only 12 countries that has been given a AAA rating from Fitch. It’s also rated AAA by the other main credit agencies.
“When you look at how fast the economy is growing, what the public finance position looks like and the external finance position, all three areas are performing very well,” said James McCormack, global head of sovereign and supranational ratings at Fitch Ratings. “It’s just very solid.”
According to the European Commission, the Netherlands’ GDP is expected to grow by 2.9 percent in 2018, down slightly from 3.2 percent in 2017. It’s one of the faster-growing European Union countries, in line with the now recovering Spain, which from a growth perspective is “the Eurozone darling,” McCormack said.
While it’s a much smaller country than some of its EU peers, it should be grouped into the same category as Germany and France, according to Thomas Torgerson, co-head of Sovereign Ratings at DBRS. It has a diverse economy, strong exports, and it does a lot of trade with other European countries.
“There’s a lot of positive momentum in the Eurozone economy, and the Netherlands, as a major trading hub, is poised to benefit,” Torgerson said.
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The Janus Henderson Global Unconstrained Bond Fund has posted a 2.3 percent three-year annualized return and outperformed the Bloomberg Barclays U.S. Aggregate Bond Index year-to-date and in the past year, according to Morningstar data through Feb. 21. Though that outperformance hasn’t landed it near the top of the rankings among nontraditional bond funds tracked by Morningstar.
“While we believe prevailing market conditions merit conservative fixed-income positioning, especially in light of lofty valuations in more rate-sensitive segments of the market … we believe that higher-yielding corporate credits with durations under three years represent an attractive source of income that is often overlooked by the market,” Gross wrote to investors at the end of 2017.
In the near term, if Treasury yields continue to climb, causing U.S. bonds prices to fall, as Gross thinks they will, then we may see allocations from fund managers to foreign fixed income rise.
However, at some point U.S. bonds will start looking more attractive again.
“If we’re in a world like we were before 2008, where you can pick up a 5 percent to 7 percent return in intermediate U.S. domestics, then my tolerance for risk is going to be less,” Podnos said. “I would then move some more of my money into my home country.”
