Thursday, August 6, 2009

Fixed Income Watch – All Bonds Are Not Created Equal

Mention the word bond to a friend and watch their eyes roll into the back of their head. I don’t think it’s a stretch to say that most of the world pictures a bond to be that safe investment that delivers a coupon, eventually matures, and should yield a little better than a money market, end of story. Most don’t realize just how volatile bonds can be. At Pinnacle Advisory Group we believe bonds can have many purposes in a portfolio, and we believe it is prudent to invest in bonds for total return, not just a yield. Once you get beyond yield clipping and embrace fixed income, it is surprising just how big a world opens up to investors. Investors must assess not only interest rate sensitivity that can cause fluctuations in bond prices (called duration), but also be aware of credit risk, valuation between different bond asset classes, currency risk (for foreign bond holders), etc.

Those who don’t pay attention to the bond market might say that paying attention to what bonds you own just can’t make that big a difference in accounts that are mixed between fixed income and equities. But one look at the returns of different bond classes over a couple of time periods reveals this thinking to be a fallacy.

The chart below shows a number of fixed income sectors and their corresponding returns from the start of the equity bear market to the current market bottom in March. It then lines up the total returns for the same asset classes from the market bottom to August 5th. A few things are notable. US dollar denominated high quality bonds with a high interest rate sensitivity did the best during the recession as the markets gravitated towards quality and shunned the entire risk spectrum. On the run-up we have seen just the opposite, with low quality and non dollar denominated bonds providing the highest return, while traditional “risk free” government bonds have posted returns that have been anything but risk free.

At Pinnacle we take the time to evaluate the bond market for both its message about the economic environment, as well as to look for what we think represents the best risk/reward in any given environment. Many may continue to think that bonds are just a boring asset class that isn’t worth the time or effort to explore, but we don’t agree with that thinking. All bonds are not created equal!