From the first announcement, last spring, that the Federal Reserve intended to start tapering its quantitative-easing program, the net asset value (NAV) of most closed-end bond funds plunged. The program, known colloquially as QE3, is, unlike its two predecessor programs, open ended in its bond purchases, and was intended to go on until unemployment declined substantially. While the Fed originally set the amount at $40 billion per month, it quickly raised the amount of purchases to $85 billion per month. Indeed, since the recession of 2007-2009, the Fed has not only sought to keep short-term interest rates low, but has also brought longer-term interest rates down to rates that are often below-inflation, with the 10-year U.S. Treasury bond reaching a yield as low as 1.7% last spring. Thus bond prices, which move inversely to bond yields, reached all-time highs. However, when it became clear that the central bank would not maintain that status quo much longer, bond yields began to rise, and bond values dropped precipitously. The 10-year U.S. Treasury bond now carries a 2.7% yield, still low by historical standards but far higher than the level of a year ago.
AllianceBernstein Income Fund (ACG) took a plunge from a high of $8.40 in the spring of 2013, to a low of $6.80 that autumn. While that may not sound like an earth-shattering fall, moves of such a magnitude are extremely rare for the fund, which invests mainly in U.S. Government and Agency bonds. Such bonds are notorious for being considered virtually free of risk, which is true in the sense of default risk, the risk that the debtor will be unable to make the required payments on their debt obligations. However, with yields having reached all-time lows, investors were exposed to another type of risk, interest rate risk, the risk that a bond’s value will decline due to a rise in the interest rate that bond-buyers or other creditors will demand. Despite recent political fights over the budget and the debt ceiling, government-bond investors have yet to be significantly affected by default risk, but over the past year they have gotten slammed by rising interest rates on longer-term bonds. Thus, the fund’s NAV declined from $8.89 per share at the end of 2012, to $8.13 at the end of 2013, an unusually steep decline for the shares which have traditionally been extremely stable.
Aberdeen Asia-Pacific Income Fund (FAX) has suffered as well. The fund, which invests mainly in Asian and Australian debt, has seen its NAV drop from $7.78 at the end of 2012, to $6.89 at the end of 2013. The plunge in share price has been even more stunning, as it dropped from a 2013 high of $8.00 per share last spring, to a low of about $5.70 at the beginning of this year. This was partly due to upward pressure on emerging-market interest rates, as investors who had been reaching for yield in those markets are demanding higher rates as U.S. interest rates begin to drift toward more historically-normal levels. Even Australia, which has been largely insulated from market instability in recent years due to its natural-resource-rich economy, has seen its bond yields rise in response to the shift in interest rates globally.
Meanwhile, funds that hold high yield corporate bonds, which have traditionally been considered more risky due to default risk, and indeed have shown higher price fluctuations in the past, have suffered less than one might expect. MFS Multimarket Income Trust (MMT), for example, saw its NAV per share decline only slightly, from $7.65 at the end of 2012, to $7.50 at the end of 2013. Indeed, the risk premium afforded to high-yield bonds may be providing some safety for investors, as the biggest risk to bond prices at this stage appears to be that of rising interest rates across the board due to a normalizing of the Fed’s monetary policy. Indeed, with the economy gradually strengthening, a surge in corporate defaults is likely not foremost on the minds of bond market participants for the time being. However, the fund’s holdings still bear real risks, as high-yield bonds are likely to see similar woes to emerging-market bonds going forward, as bond investors are approaching a situation in which they soon will no longer have to sustain higher default risks to make positive returns in inflation-adjusted terms.
With the Federal Reserve continuing to taper its bond purchases, and Fed Chairwoman Janet Yellen’s recent statements implying that increases in the Fed funds rate would only lag the end of quantitative easing by about six months or so, further rises in long-term bond yields seem likely over the next few years. As a result, investors in bond funds, such as those mentioned above, should keep the downward risks to each fund’s NAV per share in mind, and consider whether the yields being paid by these shares sufficiently compensate them for that risk.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.