Term Trusts

A number of the mortgage funds are structured as finite-life term trusts and require separate consideration. BlackRock Target Term Trust, the first of its kind, was introduced in November 1988 and seeks to return $10 per share to investors on or about December 31, 2000. It initially invested about 30% of its assets in zero-coupon bonds and the balance in mortgage-backed securities. BlackRock now manages six taxable and six municipal term trusts, which are profiled on its Web site (www.blackrock.com). Several other companies also offer such funds.

Term trusts pay monthly income but the payment stream will not remain constant, as will a bond’s. Dividend adjustments are expected due to continual reinvestment of cash flows into shorter maturity securities as a trust’s maturity approaches. Term trusts try (but do not guarantee) to pay a bit more than a bond of like maturity and quality through the use of complex strategies.

A trust’s terminal price usually is the same as its original offering price. But unlike a bond, the target price is not guaranteed. A trust could return less than 100% of its target, as several did in the 1990s. These trusts lost money as they stumbled by trying to earn extra yield with mortgage derivatives. Further, a trust may not hold sufficient zero coupon bonds to ensure that it can meet its target. BlackRock 1998 Term Trust was the first to meet its target—it paid shareholders $10.02 in December 1998. Like a bond, a term trust becomes more conservative as it approaches termination. A trust that matures in 2001 will not have the same potential for appreciation as one with a 2010 target. In addition, a term trust’s discount typically narrows as maturity nears. Trusts with more distant maturities sometimes trade at double-digit discounts. 


High-Yield Funds

Below investment-grade bonds are the focus of high-yield (or junk bond) funds. Some issues may even be near, or in, default. The closed-end format has a special advantage for a high-yield portfolio, as managers are not forced to sell illiquid holdings to raise money to redeem shares. High-yield bond returns tend to have relatively low correlation with returns of other bond groups. When the economy is strong, junk-bond issuers generally fare well. If the Federal Reserve raises interest rates to cool an expansion, interest-sensitive Treasuries and other long-term bonds can be hit hard, but the lower duration junk bonds are less sensitive to rate fluctuations. In a recession, long-term Treasuries do well when interest rates decline and their prices rise. But high-yield issuers can be facing difficulties.

Junk bonds tend to yield two to five percentage points more than high-quality debt securities. The spread widens when lower-rated bonds are out of favor. It reached an extreme of 10 percentage points in late 1990. Contrarians become more interested when the spread is wide. This presumably would be when discounts on high-yield funds are deeper, as they were during the fourth quarter of 1999. Although they may offer higher returns, junk funds have a higher level of credit risk. In addition, some use leverage, which increases volatility.

Some high-yield funds mix floating-rate bank loans with junk bonds, which reduces their volatility. These include Debt Strategies Fund, Debt Strategies Fund II, Debt Strategies Fund III, and Senior High Income Portfolio. On average, these funds have about 40% of their portfolios invested in floating-rate loans, adding a significant element of stability. Despite their floating-rate loan holdings, these funds were recently trading at discounts in the mid to high teens.

Allocate no more than 10% to 25% of your fixed-income holdings to high-yield funds, if they appeal to you. Be prepared to reduce exposure if a recession looms on the horizon. Lean toward funds with assets greater than $100 million and an average daily volume of at least 100,000 shares to ensure adequate liquidity. Good management is essential. 
 
 
Multisector Funds

Multisector funds make good core holdings because of their built-in diversity. Such funds seek income with moderate volatility; capital appreciation is secondary. They invest primarily in three key sectors: U.S. government bonds, high-yield corporate issues, and foreign-government bonds. Macro factors such as the rate of economic activity, interest rate movements, and the changes in the dollar’s value affect the different sectors to varying degrees. For example, U.S. governments are most sensitive to interest rates, while high-yield corporates respond to changes in economic activity. Consequently, these sectors move somewhat independently. Foreign fixed-income investing provides an opportunity to take advantage of global interest rate and currency trends. Multisector funds offer active asset allocation as well as security selection. However, you don’t want a market timer that moves around too much.

Funds in the multisector category include Liberty-Colonial InterMarket Income, MFS Multimarket Income Trust, Putnam Master Income Trust, Putnam Master Intermediate Income Trust, and Putnam Premier Income Trust. Most of these funds are unleveraged. The absence of leverage combined with sector diversification helps lower volatility. The multi-sector funds use junk bonds to increase their yield but are not exposed to this sector to the extent that a pure junk fund is. A fund that is reaching for higher yields might have 50% of its assets in the junk sector. A manager could trim back riskier holdings when circumstances warrant.


Other Offerings

A wide assortment of other bond funds exists. The flexible Zweig Total Return Fund normally invests 25% to 35% in stocks in addition to its stakes in high-quality bonds and cash. When increasing risk is perceived the fund will retreat to cash. The characteristically volatile Franklin Universal Trust is a quasi-high-yield fund. It generally has 60% of its assets in high-yield bonds and 25% in utility stocks. The remainder is invested in other stocks and convertibles.

In the international arena, Global High Income Dollar spreads its assets among the world’s emerging markets, investing in bonds with little sensitivity to interest rates. Templeton Emerging Markets Income tempers the risks of emerging-market investing by focusing on bonds of stable governments and blue-chip corporations. BlackRock North American Government invests only in U.S. and Canadian government debt. First Australia Prime Income invests primarily in high-quality fixed-income securities issued in Australia. A May 1998 prospectus revision allows the fund to invest up to 35% of its assets in Asian bonds. With $1.56 billion in total net assets, the Amex-traded First Australia Prime is one of the largest taxable bond funds.

Loan-participation funds diversify their portfolios among slices of bank loans to below-investment-grade borrowers. As they have no interest-rate risk, they provide excellent diversification when mixed with stock and bond investments. Their yields range from one to three percentage points above the one-year CD rate. Five of the loan funds are exchange traded offering an opportunity to hunt for discounts. [For further information on this fast-growing category, see the October 1999 issue of the AAII Journal for the mutual funds article “Loan-Participation Funds: Broadening Your Bond Portfolio.”]



© AAII Journal May 2000, Volume XXII, No. 4