So How Does this Strategy Work?

So here we are, looking to protect our capital in a declining market, and grow our capital in an advancing market.  My suggestion is that a very smart strategy is to invest in short term government bond funds in uncertain times, and invest in high yield bond funds in more confident times.

So, why High Yield Bond Funds?  Because, believe it or not, (and the chart showing the performance of the High Yield Bond funds compared with the S&P follows below), High Yield Bond Funds act just like equities.  It is just another version of the "Risk On-Risk Off" trade that is so familiar to equities investors.  When the business cycle, or the economic outlook is Bullish, investors are willing to assume risk in anticipation of increasing stock prices which reflect increasing earnings per share.  This Bullish outlook for equities is equally persuasive for the HYBs.  The risk of a default by the lower rated issuers of these bonds diminishes with the improvement of the business climate and investors bid the bonds up.

Now the foregoing assumes a knowledge of how the bond market works.  Highly rated companies may issue what are called Investment Grade debt, which in a normal market environment will carry a coupon about 2 to 2.5 points higher than Government debt with a similar maturity.  In other words, if the U.S. Treasury 30 Year bond is being offered with a 4% coupon, an IG bond would normally carry a coupon of 6 to 6.5% for a similar maturity.  A High Yield bond of similar maturity would normally carry a coupon of 1 to 3 points more.

A bond trading at par, with a coupon of 6%, is said to be yielding 6% to maturity, with a current yield of 6%.  Of course, once that bond is in the market place, and rates begin to change, the only way to adjust the yield to maturity (and the current yield) is to adjust the price. The fact is that as interest rates increase, the value of existing bonds will decrease, and conversely, when rates decrease, the value of existing will increase.  In fact, the  rule of thumb the market uses if rates increase in the market place by 1%, the value of an existing bond will decrease $10 per year, for each year to maturity.  In other words, a $1,000 30 year Bond trading in the market place will lose $300 of value if rates increase 1%.  Conversely, if rates in the market place decrease by 1%, the value of a $1,000 30 year bond will increase $300. (In the real world, bond prices are determined by complicated mathematical formula, which considers market interest rates, ratings, coupon, maturity and tax rates..but the rule of thumb is close)

So there are 2 lessons here.. the first is that longer term bonds are very volatile.  The second is that an investor stands to make, or lose, a great deal of money as interest rates change.  In fact, the volatility and performance of HYBF tracks very closely with the stock market indexes.

Here is a chart of the Fidelity Capital and Income Fund, symbol FAGIX, compared with the S&P.  Please note that FAGIX tracks very closely the S&P, both as the index loses value and as the index advances.

Click Image to Enlarge

So lets draw the obvious conclusion.. If the HYBF advances and declines just like the S&P, why bother?  Well, because just like we only want to be in the equities market when the "Risk On" trade is working, we only want to be in the HYBF when the "Risk On" is working.  And we want to be out of the HYBF when the "Risk Off" trade is in place.

The end of this series is next... How Has the Strategy Worked?.