Boat’s sailed on QE2 – and these three bond funds should gain

With the expiration of the second round of quantitative easing scheduled for June, investors should not assume that the fixed-income markets will respond as they did at the expiration of the first round of QE.
It’s different this time, according to Michael Souers, a mutual fund analyst at Standard & Poor’s.
“At the end of QE1, the long bond rallied, but this time around, there are different sets of potential risks,” he said.
From the end of QE1, March 31, 2010, to Aug. 27, when Federal Reserve Board Chairman Ben Bernanke spoke about the possibility of QE2, the S&P 500 fell 9.7% and commodities fell by 5.2%.
Conversely, the U.S. dollar was bid up 2.3% and gold rose 11.2%.
The best-performing asset class, however, was U.S. government bonds. Indeed, long-dated Treasuries gained more than 23% over the period.
“While it may be a contrarian or counterintuitive view to think that the absence of the Fed from the bond market will lead to yields’ declining, that is exactly what happened when QE1 ended,” Mr. Souers pointed out.
This time around, however, Mr. Souers believes that the bond markets will follow a more predictable pattern that will see bond yields rise as the federal government ends its $600 billion bond-buying spree.
“It’s possible that if the economy starts to lose ground and stocks start to sell off, Treasuries might rally in a flight to quality,” he said. “But the situations in China and Japan are different now than they were in the spring of 2010.”
With a reduced demand from Treasuries from foreign countries and a renewed emphasis from within the United States on addressing the budget deficit, Mr. Souers said the longer-term government bonds might see yields climb due to a reduced investor appetite.
“There’s a lot of caution related to investing in too-long-a-duration Treasuries,” he said.
With that in mind, Mr. Souers is highlighting three bond funds that invest in short- and intermediate-term bonds.
The American Century Government Bond Fund Ticker:(CPTBX), from American Century Investments, has outperformed the U.S. Government Intermediate fixed-income peers over the past 1-, 3-, 5- and 10-year periods, with a nearly 100-basis-point outperformance over the 5-year period through March.
In addition, the fund’s net expense ratio of 0.48% is well below the peer average of 0.98%.
Dreyfus’ Bond Market Index Fund Ticker:(DBIRX) has outperformed its fixed-income peers in nine of the past 10 years, including outperforming peers by 130 basis points over the three-year period through March.
“We do note that the index fund’s new manager just took over in 2010, which detracts slightly from the fund’s appeal, in our view,” according to Mr. Souers.
The Vanguard Short-Term Federal Fund Ticker:(VSGBX), offered by The Vanguard Group Inc., is designed for investors looking to invest on the shorter end of the yield curve.
“This fund’s 30-day yield of 0.82% is slightly below the peer average of 1.04%, but we think the fund’s historical track record and low cost [0.22%] makes the fund attractive,” Mr. Souers said.