Set the Right Expectations for Your Bonds

Benz: So, Jason, one topic on your mind and my mind these days is fixed-income investing and investors' attraction to any investment that promises safety right now. Can you talk about what you make of this stampede that we've seen in the bonds and bond funds over the past couple of years?

Zweig: Yeah, I think there is a couple of interesting points to make. First of all, this has really been painted in the press, of which, obviously, I'm a member, and in the public consciousness as a retail investor mania, as if mom-and-pop investors on Main Street are barging into bonds and they've lost their minds and they're going to have their heads handed to them.

I think what's getting overlooked is it's not just retail investors who are doing this; a large part of the flows into fixed income are coming from institutions. In fact, a large part of the flows are coming from sovereign wealth funds, foreign central banks, governments like China and Japan. So, if it's a mania, or above all, mom and-pop, they've got lots of company.

My main concern is that what people are buying may not be what they think they are buying. And if you are buying the trailing 12-month performance of the fixed-income market, that's great, but that may well not be what you get over the next 12 months. And certainly bond prices today are extraordinarily sensitive to any rise in interest rates, and that's the thing people have to make sure they are comfortable with. If interest rates go up, do I have a comfortable cushion in case bond prices come down, which they will if rates go up.

Benz: Right. So related question is whether standard asset allocation models that are prescribing X percent in fixed income are relying too much on the past few decades perhaps to come up with those recommended allocations and whether investors should think about questioning those asset allocation recommendations?

Zweig: Yes. I think there is really important couple of issues here. One is that, just as, say, five to 10 years ago, most people's assumptions about the future returns on the stock market were distorted by the recent past, we're probably in the same situation right now with expectations on bonds and bond funds.

When short-term bonds are yielding 0.5% and long-term bonds are yielding 3% to 4%, if you are expecting 5% to 8%, you need to come up with a good explanation of where the rest of that return is going to come from. Unfortunately, with bonds, there is no other place for it to come from. If it's not coming from the yield on the underlying bonds, it isn't there, and it isn't going to materialise.

Investing isn't about belief in fairytales; it's about dollars and cash flows. And those bonds are not going to produce sufficient cash flows to generate 5% to 8% yields. So, everyone needs to dial their expectations down in my view.

Benz: Right. So a related question in the bond realm is indexing bonds, and this area has really come under some scrutiny in the past few years where people have said, "Well, essentially what I'm doing is I'm taking ever larger stakes in the most profligate borrowers and is that what I want to be doing." I know you are a believer in indexing, but where do you come down on that question?

Zweig: In the stock market, you can make a pretty strong case. It's not a rock-solid case, but you make a pretty good case that there is nothing so terrible about having a greater amount of your money in larger companies.

In the bond arena, you can run into the exact problem you just described, Christine, which is that the holdings of a bond index fund are weighted not by the size of the company issuing the bonds, but by the size of the bonds issued by the company. So, the more the company borrows, the more of its bonds you end up owning, and it has this perverse effect of sort of corrupting the quality of the portfolio. So, as you said, the more profligate the company, the more of a stake you end up taking in its bonds.

That's kind of troubling, and fundamental indexing, as it's often called, which weights a portfolio by things other than the size of the company stock, for example, is quite controversial in the stock market. In the bond market, it probably makes pretty good sense, especially in a high yield or junk bond fund where you really don't want to put the bulk of your money in the company that has borrowed the greatest amount of risky bonds.

Benz: Right. So, though, in terms of products on the market that do fundamental indexing in a cost-effective way, I'm guessing that you don't see a lot out there that you like, at least not right now.

Zweig: I don't think we are really there yet. The marketplace is still testing these ideas. One of the problems is they are much more prevalent among exchange-traded funds, or ETFs, than they are among the classic open-end mutual fund that's familiar to so many people. Bond investing through ETFs still has a lot of really basic procedural problems for many investors.

It's hard to get the interest income reinvested back into the fund. Sometimes you may pay a brokerage commission, there may be a time lag on when that income gets reinvested. It's going to be a couple more years I think before all those wrinkles get ironed out.

Benz: Okay. Well, thanks, Jason, for sharing your insights. We appreciate it.

Zweig: Thank you, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.