A High Yield Bond Fund Hedge Program versus "Stealth Annuities"

My largest single position in IRA's/401K's is Loomis Sayles bond fund, LSBDX or LSBRX. According to Morningstar today, LSBDX has paid 7.28% on a trailing twelve months basis. It pays monthly, and has a very strong team running it who have most of their own money in it.

 

All bonds trade on interest rates, of course, but they also trade on the "faith in the credit" of the issuer, or on "how likely are they to pay back the whole face value of their bonds". On a AAA rated bond one has no fear of repayment default, but the lower one goes on the credit ladder the more of a premium the issuer must pay to get you to buy and hold their bonds.

 

LSBDX has been very skillful, since it started in 1991, in picking higher yield bonds which it feels are mispriced or have greater value than the market realizes. Nonetheless, high yield bonds trade price wise more like stocks than bonds. The first chart shows LSBDX, VWELX (a balanced Vanguard fund), and the Dow Jones Transports (DJT) all without dividends reinvested. All three made price tops between 1998 and 2000 and all bottomed in 2002 and/or 2003. All three rose from 2002/2003 until 2007/2008 and have turned down. So LSBDX (price only) trades like a stock fund although somewhat muted in range like a balanced stock/bond fund.

 

Let me show you another reason why LSBDX on a price only basis is my favorite high yield fund:

 

  

Three of these high yield funds substantially under performed LSDBX between 1993 and August 2008. With LSBDX you are getting the yield without too much sacrifice of capital. LSBDX is up on price alone ~23% from 1993 to present while the other three funds are down from 15-45%! That's important! I would recommend that you look at any bond funds you are thinking of buying on a long term price only chart and also on a total return chart (with all dividends reinvested). I pay http://fasttrack.net/ about $400 per year for their total return fund (including ETF's and CEF's) database and software which is well worth it for my continuing research. The following chart is a FastTrack total return chart for the same four high yield funds from 2000 to the present.

 

 

After looking at both the price only and the total returns charts for these funds, choosing LSBDX is a no-brainer. With LSBDX you get high yield but you also get a quasi-equity price return. For long term investors living off their bond funds, this is extremely important. Most high yield bond funds are like an annuity in that they are returning principal to you and running down. There is nothing wrong with an immediate cash annuity. I own such an annuity, as I have written about last year. But with a high yield fund I don't want a "stealth annuity" masquerading as a bond fund. I want to spend the dividends for my monthly budget and still have a bond fund left in twenty years.

 

That said, even LSBDX lost 25% of its price (without dividends) from 1998 to 2002 because it is a quasi-equity as well as a bond fund. On the FastTrack total return chart LSBDX was higher at the 2002 lows than at the 2000 highs, and that is because of its dividends. A reasonable way to hedge the equity-like part of LSBDX in a bear market is with Hussman's HSGFX which hedges a select mid cap and large cap portfolio with short index futures options. HSGFX was up 19.75% from late 2000 (FastTrack inception date) until October 10, 2002 while the SPY (total return) ETF was down 23.16%. LSBDX lost about 10% of its price only return from the end of 2000 to October 10, 2002. So HSGFX would have completely hedged the LSBDX price only decline if bought roughly at 50% of the holding of LSBDX. Nor would one need to own $1000 of HSGFX to hedge every $2000 of the value of LSBDX. Figure out your own comfort zone on hedging your bond fund, but see (on both charts) how HSGFX has also hedged the price of LSBDX over the past year.

 

Keep in mind that HSGFX also has risen 10.59% annualized since late 2000 of which about 4% is a cash dividend earned on its hedge. In a tax-deferred retirement fund which you are drawing down, you might want to take the cash dividend and reinvest the capital gain dividends in HSGFX. To carry this line of thought even further, if you had $500,000 in a tax-deferred retirement fund you could put $400,000 in LSBDX and $100,000 in HSGFX which would have returned 6.08% based on retailing twelve month dividends. That would pay you $30,435 per year or $2536 per month. It's true that an immediate annuity would pay you probably $3300 per month for life, but you have no equity left. Whereas with 80% LSBDX and 20% HSGFX you have an equity-like premium in the package and it is hedged. It's something to think about. 

Comments

[Joe]

Now, you could also combine NIE with HSGFX for an even higher yield and probbly even better hedge. Although we do not have a long performance history of NIE. Just some thoughts...
Joe

[Tom Drake]

Since it went public NIE is down 23% in price only while LSBDX is down 7% and HSGFX up 5% on price only over the same period. I think one needs to look at yield (dividends) separately from price (capital). LSBDX is 17 years into consistent production of both dividends and capital expansion. Also a lot depends upon whether one is in the planting years of investing or the harvesting years. I'm harvesting, but I don't want to run out of seed for replanting every year.

Tom

[Tom Drake]

I forgot to turn off the MSIE automatic chart magnifier pop-up menu before snapping images of two of the charts above. Here are the two clear charts re-posted at the Jing Screencast site:

http://screencast.com/t/E3UJx4kq1U
http://screencast.com/t/Etv8LFIC

[Steve B.]

Another nice post, Tom. Keep up the good work.

Many junk bond funds lead me to this conclusion, based on price-only: most got halved in 2000-2002 equity selloff/economic recession/rising default enviro and never recovered. I assume that they will do the same or worse this time around. It is good of you to share Loomis long-term success.
Please direct me to your immediate annuity post.
Getting any closer to Rob Arnott's PIMCO AllAssetAuthority, which can go 20% equity short and uses TIPS, commodity, currency and high yield? I have been happy with its' performance and 7% yield since 02-08 purchase.