Investing for Income

Stay Above the Interest Rate Fray

Your best bets now are venerable, managed diversified bond funds. You'll get a fair yield and peace of mind.

Fixed-income veterans remember the 2013 "taper tantrum," when bond prices plunged after the Federal Reserve said it would scale back a massive bond-buying program.

This year, we are having the tantrum in reverse, a bond-buying binge that means bulls like me can claim victory. The surprisingly sharp downturn in medium-term and long-term interest rates since April is a fresh challenge for devotees of the dogma that the escalating inflation readings and strong (although temporary) economic growth will soon translate to higher rates on savings accounts and bigger cash distributions from bond funds.

The original tantrum refers to the stretch from May through early September of 2013, when 10-year Treasury yields soared from 1.6% to 3% (and T-bond prices fell by 10% or so). There was no inflation to speak of in 2013, oil prices were already high, and the 2008 economic bust was done. The surprise was the speed and the ferocity of the bond-price breakdown, not that interest rates could move up.

This year, by contrast, housing and oil prices are soaring, wages are climbing, economic growth is robust. Those seem like reasons for the Fed to stand back and let the markets push interest rates higher, and the current Fed leadership is under pressure to tighten credit or at least stay neutral – a scenario right out of any 1970s first-year economics textbook.

Instead, on Aug. 6, the 10-year bond settled at 1.30%, down from a top of 1.75% in the spring. Bond funds that started 2021 dripping red ink are now up slightly, while presumptive beneficiaries of higher rates are backtracking.

This is not a fluke. Consider this comment from Deutsche Bank Economics: "We see a more muted response of government bond yields to stronger growth and higher inflation than in the past, as central banks lean against any sharp yield rises."

Some of the best-performing income investments in recent years have been those that depend on profits from the spread between the rock-bottom short-term rates they pay to borrow and the ransoms they charge customers for credit cards, riskier mortgages, small-business loans and so forth. When this margin began widening as long-term rates were rising, share prices of these outfits went crazy.

Capital One Financial (COF) delivered a 165% total return for the past year and just granted a 50% dividend boost. New York Mortgage Trust (NYMT), which might have failed in the early stages of COVID, is up 76% for the past year and pays nearly 10% in dividends. Even comparatively staid Annaly Capital (NLY), which invests mostly in fixed-rate, government-guaranteed 30-year home loans, has a 28% one-year return. Any diversified fund of bank stocks has been a bonanza. My earlier bullishness on these investments was the right call.

The Pull of Gravity

But now I think these rockets are not going to keep flying so high. I just don’t see interest rates taking off much again, what with the Delta variant making COVID a headwind to growth and the Fed likely to hold rates as low as possible to save the Treasury interest on its bills. So, profit taking will intensify.

Your best bets now: venerable, managed diversified bond funds such as Dodge & Cox Income (DODIX), Metropolitan West Total Return Bond (MWTRX), PGIM Total Return Bond (PDBAX) and Vanguard Long-Term Investment Grade (VWESX). These funds have managers who have seen it all and represent the group that has done well over the past three months following early 2021 struggles. You will get a fair yield and peace of mind.

As for your individual bonds, hold them to maturity and be glad that defaults are all but nonexistent. You can stay comfortably above the interest-rate fray.

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