How to Invest in Bond Funds During a Bear Market

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ShutterstockWith companies seeking to lock in long-term borrowing costs, corporate bonds have gained popularity.
If it's fizzy, it's iffy. That's the key thing to know about bond funds this week.

With drama engulfing the stock market, bonds look safe. But all bond funds aren't the same, and analysts say it's imperative to understand what's in a bond fund before shifting money into it -- especially if you are seeking stability.

Right now, the most unsettled segment in bonds is funds comprised of "illiquid, lower-rated bonds in exchange-traded funds," says Dan Heckman, senior fixed-income strategist at U.S. Bank Wealth Management, based in Kansas City, Missouri. The problem there is that the funds are difficult to value and even harder to sell, but the funds trade minute by minute. That's a profound mismatch, he says, that explains why some of these funds dropped on Monday by as much as 25 percent of their underlying value.

Another sore spot is foreign bonds, thanks to turmoil in currency markets. "You can pick up some yield, based on the volatility, but that's dangerous until currencies are on firmer ground," Heckman says.

Attempting to reap high yields through bonds invariably translates to low credit quality, especially in this cycle, and that means those bonds will be more volatile and harder to manage.

Corporate bonds have been popular recently as companies seek to lock in long-term borrowing costs, says George Rusnak, co-head of fixed-income strategy at Wells Fargo Investment Institute. He anticipates a little bit of fizziness if companies in troubled sectors default, triggering shudders of additional problems. Usually, analysts say, a rush of selling indicates that a category was fizzy, though at that point there's little investors can do but gain insights to apply to the next cycle of high-yield bond excitement.

Mortgage bonds are one subsector that looks a bit carbonated, Rusnak says. Residential mortgage-backed bonds are less of a worry than bonds backed by commercial properties. "The lending standards are loosened, so there's probably going to be a little more volatility," he says.

Energy and mining is another sector that has analysts worried. Falling energy commodity prices could result in some corporate defaults. As well, the unusual turmoil in those categories ripples through related categories, such as shipping, which could undermine debt repayment for business partners.

The current conflagration is a bit of a distraction from the ongoing debate about the existence -- or not -- of a bond bubble.

The classic definition of a bubble is a disconnect between the underlying value of the bonds and the momentary market value of the bonds or bond fund. "It's when they're not being valued properly in the short term versus what they should be in the long term," Rusnak says. At the moment, rates are very low, compared with norms over the last three decades.

That's largely because the Federal Reserve and central banks of other major countries have been buying their own countries' bonds. That keeps interest rates low and stable, but it also raises the question of what will happen when the central banks sell those bonds.

Pent-Up Demand

"They took bonds from the market last year, but they'll be adding them to the market this year. Will those bonds then flood the market, so prices will be weak? We don't believe that will happen. The Fed is now discussing how it will go about selling those bonds," Rusnak says.

As well, there's plenty of pent-up demand for Treasury bonds, especially from retiring baby boomers looking for safe investments and institutions craving stable returns. "They'll easily absorb those extra Treasuries coming on board," Rusnak says.

Corporate bonds and high-yield bonds, though, react more quickly to momentary market trends, Rusnak says, and that's the issue for this week's market.

%VIRTUAL-pullquote-Safety can be at odds with risk.%He's on the lookout for a "liquidity event" within the high-yield bond sector. That could pinch some investors that had temporary amnesia about risk in their pursuit of yield. "We're trying to get people to rethink -- did you buy high-yield bonds because of the income, and did you know about the potential vulnerability?" he says.

"Safety can be at odds with risk," says Ike N. Ikeme, assistant professor of finance and economics with Salt Lake Community College. For most people, the goal is to maintain the right balance of income, growth and stability for the long haul -- a sustainable strategy that overrides momentary market bumps, he adds.

Heckman recommends sticking with domestic bonds: Treasury and municipal bonds. Analysts agree that rising interest rates are likely, but say the role of traditional bonds is still invaluable for most individual investors.

"You have to be very diversified and lean in to credit quality," Heckman says. "You may not like the returns, but you'll like the return of your principal."
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