Long-term interest rates have been declining rapidly over the past two months. The timing is still good for income-seeking investors to buy shares of bond funds and one excellent 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 S&P U.S. Treasury Bond Current 10-year Index have fluctuated over the past 10 years:
Looking back a decade puts the recent movement of yields into perspective. The yield on 10-year U.S. Treasury notes has dropped
BX:TMUBMUSD10Y
to 3.92% from 4.99% in only two months.
Why buy bonds now?
A bond’s face value (or par 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 decline automatically, so that its market yield (the coupon divided by the market price) will match that of new bonds (of similar credit quality) being issued at the higher interest rate. An investor who buys that discounted bond will enjoy a yield that is higher than the coupon. If the investor holds the bond until it matures, the issuer will pay the face value and the investor will book a capital gain.
The opposite happens if interest rates fall after a bond is issued. The bond’s market value will then increase automatically, so that an investor who buys it will get a market yield that is lower than the coupon, and book a capital loss if the bond is held to maturity and the issuer pays face value.
What has been going on over the past two months is that investors have been pouring cash into bonds to lock in higher interest rates, or to position themselves for capital gains further down the line if and when the Federal Reserve reverses direction and takes action to push interest rates lower.
The Fed’s economic projections released last week indicate three cuts to the federal-funds rate in 2024.
The Icon Flexible Bond Fund
Jerry Paul has been managing the Icon Flexible Bond Fund IOBZX for 10 years. The fund currently is rated four stars (out of five) within Morningstar’s “Multisector Bond” category, but this rating tends to move back and forth between four and five stars.
The fund’s institutional shares are available through investment advisers and through large brokerage platforms, such as Fidelity and Charles Schwab, for a $50 fee. The institutional shares have annual expenses of 0.85% of assets under management, while the fund’s Investor shares IOBAX have a 1.10% expense ratio. 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 Sept. 30. It pays a monthly dividend. If we add its past 12 monthly dividends through Nov. 30, the total payout has been $0.5957 per share, or 6.97% of Monday’s closing share price of $8.55.
Either way you look at the yield, it is much higher than the 5.02% yield-to-worst on the Bloomberg U.S. Universal ex MBS Index (the fund’s benchmark) or the 3.92% yield on 10-year U.S. Treasury notes. A bond portfolio’s yield-to-worst is similar to its yield-to-maturity, except that it incorporates bonds’ call dates. A bond (or a preferred stock) is likely to have a call date years before the maturity date, at which the issuer can redeem the security at face value. Knowing the call date is important for an income-seeking investor, especially if they pay a premium for a security. They will take a capital loss if the bond or preferred stock is called.
The Icon Flexible Bond Fund has $250 million in assets under management, which allows the fund to punch above its larger competitors, according to Paul.
“The reality is there is no competitive advantage being smart,” He said. “You have to figure out how to beat those people. The way I do it is by doing what they can’t or won’t do.”
Paul cited an example that now makes up between 18% and 30% of the Icon Flexible Bond Fund’s portfolio: Airline equipment trust securities. One of the creditors is American Airlines Group Inc.
AAL,
-8.60%.
These certificates are issued to finance the purchase of aircraft. Paul said that the securities are now collateralized at about 125% because passenger jets have held their value better than expected during a period of slow production by Airbus SE
EADSY,
+2.41%
and Boeing Co.
BA,
-1.50%.
He said this type of investment is too small to move the needle for the largest 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 nice yield, versus the competition.”
Another reason large competitors might not consider the airline equipment trust certificates is that the investor is in a second-lien position, Paul said. “I like second liens because they are typically crossover rated —BB on one side BBB on the other,” he said. In other words, he can get a higher yield on securities that are on the borderline between what would normally be considered an investment-grade rating (BBB- or higher at Standard & Poor’s) and a high-yield (or “junk”) rating. Fidelity breaks down the credit agencies’ ratings hierarchy.
Paul has decades of experience with this type of financing. He shared a story underlining how important it is for a bond portfolio manager to understand all aspects of credit risk, including bankruptcy. He cited an example of railroad boxcar financing in the 1980s, when exuberance among investors led to an oversupply. He wound up taking possession of 100 boxcars when an issuer defaulted, and had to go through the process of learning how to store them properly before eventually selling them and recovering 87 cents to the dollar of his investment.
“The right collateral can protect you an awful lot,” he said.
Paul said that investment advisers recommend the Icon Flexible Bond Fund to clients for different reasons. Some consider it to be “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 made clear that the fund is not suitable for the most conservative investors: “I wear the portfolio on my sleeve. If you think concentration in airline trust paper is a bad idea you should not use this fund.”
As of Sept. 30, larger holdings of the Icon Flexible Bond Fund included securities issued by Bank of America Corp.
BAC,
-2.13%,
Fifth Third Bancorp
FITB,
-1.03%,
Prudential Financial Inc.
PRU,
-0.09%,
Citigroup Inc.
C,
+0.66%
and United Airlines Holdings Inc.
UAL,
-8.67%.
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