If you think bonds are too dangerous now, think again

A short-term bond fund might work for you if you’re looking for income.

You’ve probably read recent headlines telling you to stay away from bonds because interest rates are rising. But such conventional wisdom might not make sense if you are looking for income and have the patience to stick with a long-term strategy.

The CM Advisors Fixed Income Fund CMFIX is a short-term bond fund managed not only for current income and capital preservation, but also to take advantage of opportunities in the market to scoop up discounted securities. That can add significantly to long-term total returns through economic cycles.

The mutual fund has a five-star performance rating, the highest, from Morningstar. We spoke with James Brilliant, the fund’s manager, about its strategy.

But, first, here’s some background:

The inverse relationship between interest rates and bond prices

The “problem” when interest rates rise is that the market values of bonds fall, so that their yields will match those of newly issued bonds with similar maturities and credit ratings. If you buy your own bonds for income and hold them to maturity, this is not an issue. You will continue to receive your income and will be paid the face value when they mature. You might have purchased your bonds at a premium or a discount, but you know before buying how much of a gain or loss you will have on the investment when the bonds mature.

“Unfortunately, there are a lot of investors who don’t understand the risks inherent in their decisions to chase yield.” (James Brilliant, portfolio manager for the CM Advisors Fixed Income Fun)

But what if you want income and wish to preserve capital, and don’t want to manage your own bond portfolios? At this time, what may be appropriate for part of your portfolio is a short-term bond fund. The yield will not be spectacular, but volatility will be relatively low, and as bonds held by the fund mature, its yield will rise as the money is invested in newer, higher-yielding paper.

Fund strategy and performance

The CM Advisors Fixed Income Fund has a 30-day yield of 1.90%. The fund’s objective is to provide income, preserve capital and boost total returns by taking advantage of special opportunities. In an interview on Feb. 6, Brilliant said his team screens for bonds “that have been sold off relative to their underlying fundamentals.”

“We can look back a year ago and see credit spreads for corporate bonds [over U.S. Treasury securities with similar maturities] widened, especially in the materials, energy and industrial sectors,” he said. When the interest-rate spreads for those sectors widened, the fund bought investment-grade bonds at discounted prices, and enjoy gains in market value when the spreads “subsequently narrowed,” he added.

Brilliant went on to say that following recessions, as the U.S. economy recovers, there are typically three cycles of widening and narrowing spreads for corporate bonds, which present opportunities to supplement income with capital gains.

At this point, corporate-yield spreads have compressed to the point “where they look expensive.” However, “at the same time, we have a higher average coupon rate relative to the duration,” Brilliant said.

The fund can purchase high-quality bonds anywhere in the world, but the fund is mainly invested in the U.S. As of Dec. 31, 44% of the fund was invested in U.S. Treasury securities, with 8% in cash and the rest in investment-grade bonds.

Among the top 10 holdings of the fund were bonds issued by Cloud Peak Energy CLD with a coupon [interest rate based on the face value of the bond] of 8.5% due Dec. 15, 2019; Great Lakes Dredge & Dock Corp. GLDD   7.375% due Feb., 1, 2019; and Alcoa Inc. AA,  5.87% due Feb. 23, 2022.

The fund has $65.6 million in total assets, while CM Advisors manages $1.2 billion, mainly in individual accounts, from hits headquarters in Austin, Texas. Brilliant said the fund’s relatively small size enables it to take advantage of discounted sectors in ways that “wouldn’t move the needle” for giant bond funds.

Here’s how the fund has performed over long periods. The following figures include cash dividends and price changes, through the end of 2016:

So the fund underperformed the index for three and five years, but it more than doubled the index in 2016 and outperformed over the two longest periods.

Here’s a different set of average performance figures from Morningstar, through Feb. 3:

So we see a similar pattern, with recent outperformance and the fund beating the index for average 10-year return.

When asked whether investors might be better served by looking for significantly higher yields with dividend stocks or preferred stocks, Brilliant said: “Unfortunately, there are a lot of investors who don’t understand the risks inherent in their decisions to chase yield.”

During 2016, investors did just that, bidding up prices for utilities and other dividend stocks to high levels relative to earnings. Some investors won’t be able to bear the inevitable price volatility, setting up major losses.

Article and media originally published by Philip van Doorn at marketwatch.com