How Thornburg Protects Bond Fund Shareholder Net Asset Values

Josh Gonze
Associate Portfolio Manager

In the year 2002, bonds completed their third consecutive year of turning in higher total returns than stocks, the first "three-peat" for bonds versus stocks since 1939-42. No one knows if bonds will extend this reign to four years, but the goal for all Thornburg's bond funds remains to offer attractive total returns, with relatively stable Net Asset Values (NAVs), whether interest rates move up, down or sideways.

This kind of performance doesn't occur by accident. While there's no magic bullet, Thornburg managers attempt to stabilize NAVs by selecting bonds that resist price erosion when interest rates rise.

• Laddering bond maturities is the first tactic used to protect shareholder NAVs. If interest rates rise, all bond prices decline. Using a laddered structure means we always have bonds maturing at par. We reinvest proceeds from maturing bonds at the new, higher rates at the far end of the ladder. This eventually compensates for price declines.
• Sticking to short and intermediate bonds is key. Long-term bonds offer a little more yield but a lot more price risk. With short maturities, a 1% yield change causes a small price change, but with long maturities, that same 1% yield change results in a big price swing-often two or three times as large as that of shorter bonds.
• A traditional Thornburg bias in favor of higher coupon bonds helps lower our funds' durations and reduces sensitivity to interest rates. The higher a bond's coupon, the less its price drops when rates rise.
• As regards tax-free funds, higher coupons have a second positive effect. Usually, the amount of tax-exempt income that can be earned from a bond is capped by the coupon rate. Bonds priced today around par ($1 for every $100 in face value) will be priced at a discount if interest rates rise. Discount municipal bonds usually suffer larger price drops than other bonds when interest rates rise because only part of their return (the coupon) is tax-exempt. The value of the discount is often ordinary taxable income, and needs to be increased to make up for the tax bill. Thus discount municipal bonds often have one-third more downside than non-discount municipal bonds. Thornburg avoids this problem by concentrating on bonds with good "coupon protection" (higher coupons).
• Emphasizing good call protection is crucial to protecting the NAV. Optional calls create negative convexity, or price bias. When rates decline, bonds with poor call protection are more likely to be called, so they underperform the market. When rates rise, bonds with good and bad call protection decrease equally in price.

By practicing the above techniques over many years, we can ensure that Thornburg Bond Funds remain structured to perform well, over time, in any interest rate environment.