Fixed-income bond funds can provide income and diversification benefits

Timothy Gigliotti, Managing Director and Head of Asset Management Public Bond Trading

Click here for the downloadable version. (PDF)

Fixed-income bond funds can play an important role in almost any investment portfolio by providing regular income and adding diversification benefits. Timothy Gigliotti, TIAA-CREF’s Managing Director and Head of Asset Management Public Bond Trading answers some frequently asked questions about fixed-income bond investing.

What are the main benefits of fixed income bond funds? What makes them attractive to investors?

Timothy: Fixed income securities provide portfolio diversification, a steady stream of income that act as a cushion against the ups and downs of the stock market. The coupon payments (yield) that the portfolios generate help to provide a source of income to the fund shareholders, or they can be reinvested back into the fund to increase their share holdings.

Can you discuss the various types of bonds available? How do they work?

Timothy: There are a broad array of fixed income securities, including U.S. Treasury and Agency debt, mortgage backed securities, asset backed securities, investment grade corporate bonds, high yield corporate bonds, emerging markets debt and municipal bonds. Fixed-income securities pay periodic interest, usually monthly or semi-annually. When the bond matures, the principal is repaid to investors.

How do interest rates impact bond prices and yields?

Timothy: The price of a fixed-income bond and its corresponding yield are inversely related. Therefore, when interest rates are declining, the price of a bond will increase as the market adjusts to reflect the value of the higher fixed coupon payment attached to that bond. Conversely, when interest rates are rising, the price of a bond will decline.

How are bonds rated?

Timothy: The public bond market generally recognizes three independent rating agencies when it looks at the credit worthiness of a bond issuer. The agencies include Moody’s Investors Services, Inc., Standard & Poor’s Ratings Services and The Fitch Ratings Group. The rating agencies assign a “letter grade” to the borrower based on their internal assessment of the risk to the lender that the borrower will make timely interest payments and ultimately repay the principal balance at maturity. For instance, the letter grade spectrum runs from “AAA” as the highest rating down to “CCC” as the lowest rating above “D” for a defaulted security.

What are some of the factors behind bond credit risk?

Timothy: Factors that can affect the credit worthiness of a bond issuer include: the consistency and responsibility of its management team; its debt levels or leverage ratios; its capacity to generate free cash flow; and its sensitivity to the economy and business cycle.

What are some of the current challenges facing fixed income funds?

Timothy: The primary challenge facing fixed income bond funds and the bond market as a whole is the current low interest rate environment. Consequently, investors seeking higher returns are forced to look at longer maturing bond funds or even lower rated (riskier) securities.

Do bond funds move in tandem with stock funds?

Timothy: The correlation between equity funds and fixed-income funds varies widely. Nevertheless, some basic relationships exist. For example, high-yield funds, those that invest in companies which carry high debt loads and are tied to the strength of the economy, tend to perform better when stocks do well and vice-versa. U.S. Government debt and other highly rated debt tend to have a more inverse relationship and benefit in times of uncertainty, as demand for quality and safety drives their prices higher while stock prices typically decline under those same conditions.

What factors should you take into consideration before investing in a fixed income fund?

Timothy: Investors should consider their tolerance for risk, their need to sell fund holdings for whatever reason (to purchase a home, college tuition, living expenses and other emergency expenses) and their overall mix of investable assets. It is also important to look at the fees bond funds charge given that the expected returns are lower than equity funds and therefore fees can be a significant drag on overall return or performance. Finally the experience of the fund management team should be considered.

What is TIAA-CREF’s investment philosophy in this asset class? What are your investment themes?

Timothy: TIAA invests in fixed-income assets for the same reasons that individual investors do. It is a steady source of investment income and, depending on the asset class, there is a high probability of receiving your initial investment back. We invest in bonds that our analysts and portfolio managers think offer an attractive risk-adjusted return, while adhering to a conservative value oriented approach.

What is the outlook for the asset class? Where do you see the most growth opportunities for investors?

Timothy: We expect interest rates to remain at or close to these levels for the foreseeable future. The Federal Reserve has stated that they are likely to keep the Fed Funds rate in a range from 0% to 0.25% through the middle of 2013. Despite the low interest rate environment and economic outlook, we still think there are attractive investment opportunities in a number of asset classes including investment grade bonds, high yield bonds, emerging markets debt, asset-backed and mortgage-backed securities for investors willing to do the credit research or in funds with strong management teams.

Do you have any take-away points for investors?

Timothy: If you are contemplating buying a bond fund, do some homework on the fund’s investment approach, management experience and performance across various time periods and economic cycles. Finally, only purchase funds that are then aligned with your individual goals and tolerance for risk.

TIAA-CREF NEWS ARCHIVE

C1645