What Caused My High-Yield Bond Fund to Do 'The Chicken'?

What happened to (MCHIX Quote)Merrill Lynch Corporate High Income Portfolio; C on the first of August? No other fund seems to have been knee-dropped like that and made to do "The Chicken."

-- Pat Wilson

Pat,

Au contraire! Virtually every fund in the universe of high-yield bond funds was, as you put it, knee-dropped and made to do "The Chicken" in late summer and early fall, as investors fled all kinds of risky assets.

From July 31 to Oct. 19, the fund you ask about, MCHIX, saw its net asset value drop from $8.03 to $6.70. Over that period, its total return was negative 14.69%, and its principal-only return was negative 16.56%, according to Lipper.

The total return figure is worse than average; the average high-yield fund returned negative 11.24% over the period. The principal-only return is worse than the average of negative 12.95%.

I thought it might be useful to chart MCHIX's net-asset-value change over the past year against both the best- and worst-performing funds in its category. As you can see if you click here, MCHIX looks pretty bad alongside (STHBX Quote)Strong Short-Term High-Yield Bond, the fund with the second-highest total return for the year through Nov. 30 (the best performer, UBS High-Yield Bond, isn't big enough to have a Nasdaq symbol). But compared to (NNHBX Quote)Northstar Total Return; A, the worst of the bunch over that period, it's the belle of the ball.

More on TIPS

The discussion of Treasury Inflation-Protected Securities, or TIPS, on Dec. 18 prompted reader Rich Schneider to ask:

• Would one ever want to own TIPS in a nontax-deferred account?
• Could there be trading gains in TIPS if inflation were to heat up?
• Could a change in supply/demand for regular Treasuries make TIPS less attractive?

Regarding taxes: I pointed out that investors buying TIPS outside of a tax-deferred account should be aware that as with zero-coupon bonds, they'll owe taxes on the accrued principal each year.

If you don't mind paying taxes on money that's not actually being paid to you -- a problem that regular bonds don't present -- there's no reason not to own TIPS in a nontax-deferred account.

Having to pay tax on TIPS is less inconvenient than having to pay taxes on zeros because, unlike zeros, TIPS pay interest that can be used to pay the taxes. It's possible, however, that if the rate of inflation as measured by the consumer price index were to shoot up, the coupon income wouldn't be enough to cover the tax bill on the accreted principal, says Will Lloyd, head of market strategy at Barclays Capital. Of course, Lloyd adds, if the CPI were to shoot up, you'd be glad you owned TIPS instead of regular Treasuries.

Regarding trading gains: I explained the basic principle that if inflation outpaces the rate implied by the difference between TIPS yields and regular Treasury yields at the time of purchase, the TIPS investor will come out ahead. That's true, but remember that if inflation is rising, no bond is likely to perform well. If inflation's rising, TIPS should outperform regular Treasuries, but that might mean only that you'd lose less in TIPS than in regular Treasuries.

David Schroeder, manager of American Century-Benham Inflation-Adjusted Treasury, gave me this example: Suppose you bought the 10-year TIPS today at a yield of 3.80%. If the annual rate of CPI inflation were to shoot up to 3% from 1.5%, the annual income return on the bond would be about 6.80%, the sum of 3.80% and 3%. But if that increase in inflation were accompanied by a 50-basis-point rise in the TIPS yield to 4.30%, the bond's price would fall by a little more than 3%, eroding its total return and wiping out the possibility of a trading gain.

"Over a short investment horizon, it's the direction of yields that will have the big impact on the returns of these securities," Schroeder says. "An investor looking at these should be looking at them over a longer horizon. The longer you hold a bond, the less impact changes in price have on a return."

Of course, there's no guarantee that a rise in CPI inflation would cause TIPS yields to rise, Schroeder says. They might even fall, as demand for them -- currently close to nonexistent -- increased. But you can't count on that.

In the meantime, the relative illiquidity of TIPS makes it doubtful that individual investors can squeeze trading gains out of them. The small number of buyers for TIPS means wide spreads between bid and asked prices, especially for small lots. In a market where guys like Schroeder complain about the difficulty of selling $16 million lots at a good price ("The markdown wasn't huge, but it was substantially larger than for a regular Treasury security," he says of a recent transaction), individuals don't stand a good chance of salvaging much of a gain from the bid-asked spread when they trade.

"There are potential price gains, but because the market's illiquid, you might not get as much of a price gain as you'd expect if inflation were to pick up," Schroeder says.

Regarding supply/demand dynamics: With the federal government running a budget surplus, issuance of regular Treasuries has fallen off sharply, and with inflation in retreat, there's been very little demand for TIPS. Those trends have benefited regular Treasuries massively, while TIPS have underperformed. The question is: Do you think the supply/demand dynamics can get any better for Treasuries? Because if those trends reverse, TIPS should outperform regular Treasuries. Again, that doesn't mean they'll do well. "In a rising rate environment, the total returns of TIPS will, without a doubt, be better than nominal Treasuries' of the same maturities -- they won't be as negative," Schroeder says. In other words, if you want to bet that interest rates are going to rise, forget TIPS and buy yourself some short-maturity instruments.