The Total Return Approach

By Jon Orcutt of AllocationForLife.com

Are you investing in individual bonds, bond mutual funds or bond ETFs to stabilize your portfolio throughout retirement?  If so, you are not alone.  Asset allocation once again became important to investors after the market meltdown of 2008.  Reducing volatility throughout retirement is the ultimate goal for most investors. However, if you think all bonds are created equal then you may get caught on the wrong end of the yield curve. If this happens, then a whole new generation of individual investors will find out that their asset mix, which was designed to reduce volatility, actually may become very volatile.

The problem I see is the mad rush into long-term bond mutual funds and ETFs as individual investors are hungry for yield and chasing returns. The sophisticated investor, I am quite confident, will be able to take advantage of rates at zero and will be smart enough to lock in gains at some point in the future. However, the majority of individual investors are not sophisticated, and they are using these types of funds as a long-term solution to provide stability in their asset allocation models. I suggest they take a look at the not-so-distant past and see how this mix worked out in the “risk off” environment of 2008 and first quarter 2009.

Between 2008 and the end of the first quarter of 2009 the average total return for long-term bond, multi-sector bond, national municipal bond, high yield bond and high yield muni bond mutual funds were as follows:

2008 Total Return

Long-Term Bond


Multi-Sector Bond


National Muni Bond


High Yield Bond


High Yield Muni Bond


Many individual investors do not understand interest rate risk and the potential negative impact it may have on the bond side of their investment equation. With interest rates at zero it does not take much insight to realize that at some point, rising interest rates will send long-term bond prices down.  It is just a matter of “when” rather than “if”. This rise in interest rates could come from an explosion in inflation, which is not good for anyone, or from strong economic growth over the next few years.

Understanding what type of bonds you own is essential, especially for retired investors. When designing tactical allocation strategies, you must consider the bond side of the equation sacred. That is the part of the portfolio that many rely on for price stability and to help drive down the overall beta (risk) of a portfolio when compared to the equity markets. Investors need to understand that if they own a long-term corporate bond fund/ETF or a municipal bond fund/ETF, and today are enjoying the higher yield, that these investments are mandated to own these types of bonds. There is very little room to maneuver and these fund managers need to remain fully invested at all times. You need not look any further than 2008 to see what this could mean for these types of bond funds.  Long-term interest rate risk should be enough to worry about at this time, but in addition to interest rate risk, bond investors also need to worry about “credit risk”.  From the credit risk environment in Europe to the growing number of municipalities in the United States struggling, it is obvious the credit problems continue to persist.  The year 2008 was a perfect example of what is called a “risk off” environment. Anything that did not provide a guarantee experienced a vicious downturn.

The fact that interest rates are at zero obviously scares me. However, the fact that long-term bond prices have been sent artificially higher by the Fed’s latest easing program scares me even more. Due to the fact that interest could not be lowered any further it has led the Fed to come up with new and creative ways to try and stimulate the economy. The Fed’s newest approach is being referred to as “Operation Twist”. What is Operation Twist? Basically the Fed can’t reduce short-term interest rates any further because they’re already at zero. Therefore, the Fed wants to reduce long-term interest rates instead. They do this by selling short-term bonds and using the proceeds to buy long-term bonds. When you buy more of something, you raise the price. When you raise the price of a bond, you lower the interest rate. So what the Fed is doing is artificially lowering long-term interest rates.

What will happen to long-term rates when the Fed is done with its easing program? If Operation Twist does its job, and the economy continues to improve, then this will be great for equities. However, it will also allow the Fed to gradually release their stranglehold on interest rates. Long-term rates will then be allowed to rise, and this will have a negative impact on long-term bond prices.  The other concern economists have with all of the Fed’s quantitative easing programs is the negative impact that they may have on the U.S. dollar and many believe the programs will send commodity prices higher.  If massive inflation is an end result to the easing programs, then the only weapon the Fed has to offset inflation would be to aggressively raise interest rates, and this would not be good for long-term bond holders.

What other reaction did we see when the Fed announced its Operation Twist program? Immediately after the announcement a huge amount of institutional money funneled into Treasury Inflation Protected Bonds (TIPS). Think about that for a second. Immediately after the announcement of Operation Twist, the smart money chose to move into a negative yielding TIP, while individual investors moved more money into long-term bond funds and ETFs.


The Total Return Approach

If you are using an asset allocation mix to provide stability, then it is essential to take a “total return” approach.  Taking a “total return” approach to buying bonds simply means you are focusing on how the overall bond will perform.  This includes both the price and the yield (% the bond is paying in relation to its current price) the bond is paying.  Many of us do not have the expertise or tools to navigate the vast and complex world of the credit markets.  That means you may be much better off hiring a total return manager to do this for you.  These types of managers have a tremendous amount of flexibility. They not only have the ability to move to a large cash position when they see risk on the horizon, but they also have the ability to own any type of fixed income instrument that they feel could provide the highest total return.  Sometimes that means the best total return may be no return versus losing 15% of the portfolio’s value.

The main problem I see with managers within the total return bond sector is that they are automatically lumped in with other funds based upon their current portfolio weighting. Yes many of these funds and ETFs, based upon their current positions, could be viewed as short-term government securities funds, but in reality they offer so much more with a tremendous amount of flexibility.  Unlike corporate bond, municipal bond and U.S. Treasury bond funds that have to invest specifically within those sectors, a total return bond manager is not handcuffed by these restrictions. Good total return bond managers will try to position their portfolios in fixed income securities that they feel offer the potential for the highest total return on investment.  Do you think a high quality corporate bond fund manager was happy that he or she had to own corporate bonds in 2008? I’m sure they saw risk all over the bond horizon but there was not much they could do about it because they were mandated to own corporate bonds. I have already shared with you the average performance for various bond funds between 2008 and the end of the first quarter of 2009.  In that same time period, Bill Gross guided the PIMCO Total Return Fund to a gain of 5.96%. The total return approach gave Gross the flexibility to avoid areas of the bond market that others could not. Again, not all of the others are bad managers, but they simply had to stay within their sectors.  When the fixed income sector you are mandated to own is out of favor, there is not much you can do about it.  I have a large amount of respect for the management team of the Loomis Sayles Bond Fund (LSBRX). They are great corporate bond managers.  However, being great at something does not help you when nobody wants to own corporate bonds.  Between 2008 and the first quarter of 2009 the fund lost 22% of its value.  Between April 2009 and the end of second quarter of 2012 the fund gained over 70%.  This wild ride, or volatility, may be acceptable to many investors, but it does nothing to reduce volatility if that is your goal.

Sometimes the best offense is simply a good defense and that is why I prefer the total return approach to owning bonds within a strategy that deploys tactical allocation. I want a manager that can focus on total return and capital preservation, and has the ability to sit on a tremendous amount of cash. Not being mandated to invest a minimum percentage of your portfolio in a specific sector (ex. corporate bonds) gives these managers that ability.  Unfortunately, the pickings are slim for investors.  There are very few pure total return fixed income managers available.  The answer for many investors may lie with the PIMCO Total Return ETF (BOND) that was launched earlier this year.  The ETF is managed by Bill Gross and his team and deploys the same total return fixed income strategies that Gross has used so successfully over the years.   The man has earned the title “Bond King” for good reason.  At this time, BOND offers much more flexibility for Gross than the PIMCO Total Return Fund.  The managed mutual fund has been around for many years and is the largest mutual fund in the world.  While shareholders have experienced the reward, the newly launched ETF has shown that it pays to be nimble.  Between March 1st of this year and the end of the second quarter BOND gained 6.26% while the PIMCO Total Return Fund (PTTRX) gained 2.84%.  The yield is not impressive, but the beta is exactly where it should be if you are looking for a fixed income investment to reduce volatility. Understanding beta is quite simple.  If a particular investment has a beta equal to 1, then that investment is trading at the exact same volatility as the S&P 500.  A beta greater than 1 means that investment is trading with a higher level of volatility, some say risk, than the market.  Although BOND has not been around long enough to provide us with its beta versus the S&P 500, it is safe to assume its beta is very similar to the PIMCO Total Return Fund (PTTRX).  The funds trailing one year beta is .50, and that is exactly the reduced volatility I have come to rely on from the total return approach to investing in fixed income.

Retired investors and investors on the verge of retirement must learn to use the bond side of their investment mix as a measure of safety, and should stop chasing yield and capital appreciation without understanding the principal risk they are assuming. High yielding closed-end funds that use leverage to stabilize their net asset values, and long-term bonds are all facing interest rate risk in the coming years. If stability is your goal, then you must use a total return approach to owning bonds.


About Jon Orcutt

Jon R. Orcutt has over 15 years of experience in the financial services industry. He is an Asset Allocation Strategist and Author.

Jon has recently finished his first book, “Master the Markets with Mutual Funds: A Common Sense Guide to Investing Success“. His extensive experience working exclusively with individual investors, gives him unique insight into what makes a successful investor. His past “common sense” approach with clients has translated into a down-to-earth writing style that provides readers with a realistic guide to building sustainable wealth.


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Idan Levitov


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