Fund name: T. Rowe Price Strategic Income (PRSNX)
Objective: The fund seeks "high income and some capital appreciation." Their target is to produce returns comparable to those available from high-yield (i.e., junk) and international bonds, with a degree of downside protection. It hopes to achieve that end by investing primarily in income-producing instruments including:
The fund may invest entirely in dollar-denominated foreign securities; other than that, there are pretty clear caps of their exposure to any particular class of securities. By way of example, both convertible securities and preferred stocks are capped at 15% of the portfolio. The managers will actively allocate the portfolio based on market conditions.
Adviser: T. Rowe Price. Price was founded in 1937 by Thomas Rowe Price, widely acknowledged as "the father of growth investing." The firm now serves 11 million retail and institutional clients through more than 450 separate and commingled institutional accounts and more than 90 stock, bond, and money market funds. Price had $345 billion under management at mid-year.
Managers: The fund is managed by a five person team. The lead manager, Steven Huber, is responsible for the fund’s critical asset allocation decisions. Before joining Price in 2006, he managed the State of Maryland’s retirement fund for three years. From 1987 – 2003, he was the director of asset allocation and quantitative strategies for Aeltus Investment Management. Aeltus is an institutional money manager, once part of Aetna (hence the funky spelling) and now part of ING. Michael Cornelius, Andrew McCormick, Michael McGonigle and David Stanley are each responsible for individual security selection for particular sectors (e.g., emerging markets debt).
Inception: December 15, 2008.
Minimum investment: $2,500 for regular accounts, $1000 for IRAs. Price waives the investment minimum for folks who set up an automatic investment program (AIP) at $50 per month or more.
Expense ratio: 0.80% after waivers, which are in force through September, 2011.
Comments: The unending problem with investment grade bonds is that they simply don’t return enough – especially after taxes – to give investors meaningful inflation protection. Jack Bogle, in Bogle on Mutual Funds, estimated a 4.6% annualized return on long-term government bonds from the late 19th century on (pg 5). Bill Bernstein refuses even to discuss long-term government or corporate bonds in his Four Pillars of Investing because "they do not have an acceptable risk/return profile" and are "generally a sucker’s bet – they are quite volatile, extremely vulnerable to the ravages of inflation, and have low long-term returns" (pp 113-114). There are, however, bonds which produce equity-like returns with less long-term risk: high-yield bonds. From 1988-2006, for example, the Merrill Lynch High Yield Master Index returned 9% annually with a standard deviation (a measure of volatility) of 6.7%. For that period, high yield bonds offered 80% of the stock market’s returns with only 50% of the volatility.
This apparently-muted risk is, however, deceptive. Corporations have to offer high yields on their bonds when there are discernible questions about the company’s future ability to make its bond payments; that is, the higher yield is a manifestation of a default risk. Such questions arise mostly in bad economic times, which is also the time that the stock market is most likely to decline. As a result, high yield bonds tend to follow the stock market down. In 2008, the Fidelity, T. Rowe Price and Vanguard high yield bond funds – all tabbed as Morningstar "analyst picks" – lost an average of 25%.
The logical solution for income investors is to include, but actively manage, a set of high risk bonds. In theory, you would aggressively invest in high yield bonds at the outset of an economic recovery, hold them in periods of ongoing growth, and lighten up when the economy begins to soften. Various financial models suggest that a managed 25% stake in high yield bonds can increase a bond portfolio’s return by 2% or so while not raising its volatility. Unfortunately, very few people have the insight or discipline to pull it off. As a result, many bond investors end up settling for pitiful, but predictable, returns.
The alternative proposed by some advisors has been multi-sector bond funds, often called "strategic income" funds. These funds generally attempt to actively manage a collection of higher-returning income investments – including preferred shares of stock, REITs, emerging market debt, high-yield bonds and so on – in a way that allocates more to ascendant sectors and less to declining ones as economic conditions change. The end-product, with luck, is better-than-bond returns and better-than-equities consistency.
Fidelity’s version, Fidelity Strategic Income (FSICX), is a good representative of the genre. It outperformed the broad bond market about two-thirds of the time and, until 2008, had never lost money. In 2008, it lost 12% against a 40% decline the stock market. More importantly, many of the individual components which make up the fund’s portfolio lost a lot more than the fund itself did: emerging market debt (down 19%), high-yield debt (down 29%) and bank loans (down 31%, all through 12/24). By combining and intelligently recombining individually risky assets, Fidelity’s managers were able to create a whole greater than the sum of its parts.
Bottom line: Price generally does a very solid job with its bond funds. By way of example, 13 of their 16 income funds earn four- or five-star ratings from Morningstar and five of them are "analyst picks." Only one – Corporate Income (PRPIX) – has fewer than three stars. On whole, they’re intelligently designed, well-managed and don’t take silly risks. Folks anxious to add a percent or two to their bond portfolio’s returns might reasonably consider adding a slice of the Fidelity or Price Strategic Income funds to an otherwise-vanilla bond mix.
Company link: T. Rowe Price Strategic Income fund
January 1, 2009