Long-term interest rates have been falling rapidly over the past two months. It’s still a good time for income-seeking investors to buy shares of bond funds, and one prime example is the ICON Flexible Bond Fund, which is managed by Jerry Paul.
During an interview with MarketWatch, Paul described his advantages over the largest bond portfolio managers, such as Pimco and BlackRock. He also provided a fascinating example of how his specialization can help investors.
First, take a look at how yields for the current 10-year S&P US Treasury Bond Index have fluctuated over the past 10 years:
Looking back a decade shows the recent movement of yields. The yield on the 10-year U.S. Treasury note has fallen BX:TMUBMUSD10Y to 3.92% from 4.99% in just two months.
Why Buy Bonds Now?
A bond’s face value (or face value) is the amount the bondholder will be paid by the issuer when the bond matures. The interest rate based on the face value is called the coupon. If interest rates rise after a bond is issued, its market value will automatically decrease so that its market yield (the coupon divided by the market price) will match that of new bonds (of similar credit quality) issued at a higher interest rate percent. An investor who buys this bond at a discount will enjoy a yield that is higher than the coupon. If the investor holds the bond until maturity, the issuer will pay the par value and the investor will realize a capital gain.
The opposite happens if interest rates fall after a bond is issued. The bond’s market value will then automatically increase, so an investor who buys it will receive a market yield that is less than the coupon and will record a capital loss if the bond is held to maturity and the issuer pays par.
What’s been happening over the past two months is that investors have been pouring money into bonds to lock in higher interest rates or position themselves for capital gains down the road if and when the Federal Reserve changes direction and takes action to push interest rates lower.
The Fed’s economic projections released last week showed three cuts in the federal funds rate in 2024.
The Icon Flexible Bond Fund
Jerry Paul has managed the Icon Flexible Bond Fund IOBZX for 10 years. The fund is currently rated four stars (out of five) in Morningstar’s Multi-Sector Bond category, but that rating tends to bounce back and forth between four and five stars.
The fund’s institutional shares are available through investment advisers and through major brokerages, such as Fidelity and Charles Schwab, for a fee of $50. Institutional shares have annual expenses of 0.85% of assets under management, while the investor shares of the IOBAX fund have an expense ratio of 1.10%. All further references to the Fund in this article will be to the Institutional Share Class (IOBZX).
The fund quoted a 30-day SEC yield of 7.13% as of September 30. It pays a monthly dividend. Adding the last 12 monthly dividends through Nov. 30, the total payout is $0.5957 per share, or 6.97% of Monday’s closing stock price of $8.55.
Any way you look at the yield, it’s much higher than the 5.02% yield on the worst-performing Bloomberg US Universal ex MBS Index (the fund’s benchmark) or the 3.92% yield on US 10-year Treasuries . The yield to worst of a bond portfolio is similar to the yield to maturity, except that it includes the bond’s maturity dates. A bond (or preferred stock) will likely have a call date years before the maturity date at which the issuer can redeem the security at par. Knowing the call date is important to the income-seeking investor, especially if he is paying a premium for a security. They will suffer a capital loss if the bond or preferred stock is called.
The Icon Flexible Bond Fund manages $250 million in assets, which allows the fund to outperform its larger competitors, according to Paul.
“The reality is there’s no competitive advantage to being smart,” he said. “You have to figure out how to beat these people. The way I do it is by doing what they can’t or won’t do.
Paul cites an example that now makes up between 18% and 30% of Icon Flexible Bond Fund’s portfolio: airline equipment trusts. One of the creditors is American Airlines Group Inc.
AAL
.
These certificates are issued to finance the purchase of aircraft. Paul said the stock is now about 125% collateralized as passenger jets have held their value better than expected during a period of slow production at Airbus SE
EADSY
and Boeing Co.
B.A
.
He said these types of investments are too small to move the needle for the biggest bond fund managers. He added that the small size of his portfolio means he can take concentrated positions “to get what I think is a really good return relative to the competition.”
Another reason major competitors may not consider airline equipment trust certificates is that the investor is in a second-bet position, Paul said. “I like second liens because they’re usually crossover rated —BB on one side BBB on the other,” he said. In other words, it can get a higher yield than securities that are on the border between what is generally considered an investment grade rating (BBB- or higher at Standard & Poor’s) and a high yield rating ( or “trash”) . Fidelity breaks down the hierarchy of credit agency ratings.
Paul has decades of experience with this type of financing. He shared a story highlighting how important it is for a bond portfolio manager to understand all aspects of credit risk, including bankruptcy. He cites the example of rail car financing in the 1980s, when investor exuberance led to oversupply. He found himself in possession of 100 railcars when an issuer defaulted, and had to go through the process of learning how to store them properly before eventually selling them and recouping 87 cents on the dollar of his investment.
“The right collateral can protect you a lot,” he said.
Paul said investment advisers recommend the Icon Flexible Bond Fund to clients for a variety of reasons. Some consider it a “conservative high yield fund,” he said, while others consider it an “alternative fund” or because it has a short average effective duration of less than three years.
He clarified that the fund is not suitable for the most conservative investors: “I carry the portfolio on my sleeve. If you think that concentration in airline trusts is a bad idea, you should not use this fund.”
As of September 30, Icon Flexible Bond Fund’s largest holdings include securities issued by Bank of America Corp.
BAC
,
Fifth Third Bancorp
FITB
,
Prudential Financial Inc.
PRU
,
Citigroup Inc.
° С
and United Airlines Holdings Inc.
UAL
.
Do not miss: Are bank stocks poised for a rebound? Three picks for 2024
