In the spring of 1987, the interest rates on newly issued long-term U.S. treasury bonds spiked, and from March until October the shares of Vanguard's Long-Term Treasury fund dropped 20 percent from $10.34 per share to $8.34. But, by the end of 1990, the share price had largely recovered (at $9.70 and rising). The interest payments, per share, never dropped at all, and thanks to the addition of new bonds enjoying higher interest, the income was actually rising.
Why does this matter today? Because anyone struggling to eke out more income from investments needs to gain a level of comfort from investing in bonds, and that only comes from reviewing what happens when the guano hits the fan.
If you're someone who thinks they can shift between bond funds and stock funds at opportune times, beyond just rebalancing, then this column is not for you. The financial service industry is littered with the bones of self-styled professionals who thought that they could do that successfully over a sustained period of time.
Instead, the following ideas are for people who want to invest in fixed-income investments a little more aggressively to generate higher rates of return -- while learning to live with fluctuating capital values. Keeping the eye on the ball is paramount, and the ball itself is the actual amount of interest paid per share on your bond funds.
If you're at a point in life where you are resigned to investing a portion of your portfolio in bonds indefinitely, you have the luxury of being able to ignore changes in the capital value. They will fluctuate, much like the U.S. treasuries mentioned above, but the interest that you're using for income will continue as a relatively steady stream into your checking account each month. To clarify what can be confusion regarding terminology, interest earned on bonds is actually expressed as "dividends" when paid out by the mutual fund.
Take, for example, the T. Rowe Price High Yield Fund (PRHYX). The dividend per share was 52 cents from 2005 through 2007 and then dropped to 48 cents in 2008 and 2009. It rose to 52 and then 50 cents in the two subsequent years and has now dropped to 44 cents this year.
Right in the middle of this stretch, the capital value dropped by 24 percent in 2008, but more than recovered with a 49 percent gain in 2009. See what I mean? At its lowest share price point of $4.60 in early 2009, the dividend chugging along equaled an 11 percent annualized rate of return. Today, even at 44 cents, the dividend represents a 6 percent rate of return on a share price of $7.20.
So here's a novel thought. If you're still concerned about losing capital permanently by investing in a bond fund earning 6 percent currently, consider spending just 3 percent of the current 6 percent dividend and have the remaining 3 percent reinvested in the fund so that the number of shares actually grows over time. You endure some capital fluctuation, but you beat the 1 percent return in the short-term bond fund that people like Bob Brinker currently recommend.
The same concept can be applied to a new fund, which is Vanguard's Emerging Markets Government Bond Index Admiral (VGAVX). This fund offers the same 6 percent dividend as a percent of its current share price and it is dealing in dollar-denominated foreign debt, so the risk of currency exchange fluctuations is not a factor that would increase risk.
Other funds investing in emerging markets have had capital losses this past year, but they were typically not confined to just government debt. There is more risk, in other words, if you're invested in companies in places like Latin America, Africa and Asia and you're not protected against currency fluctuations.
It's too early to know how well Vanguard's new fund will fare, but even more risk-prone bets on the developing world in funds like T. Rowe Price Emerging Markets (PREMX) have had share prices fluctuating between $14 and $12, but the dividend has remained steady at about 80 cents a share. Its most recent dividend rate was 71 cents -- about what it was in 2003 when the share price was equivalent to today's value.
When it comes to bond funds, it can be déjà vu all over again. Again and again. Investing in one of them is like riding a Ferris wheel as opposed to a roller coaster.
Steve Butler is CEO of Pension Dynamics. Contact him at firstname.lastname@example.org or 925-956-0505, ext. 228.