NEW YORK – Oh, right. Stability. That's what bond mutual funds are for.
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When stock markets tumbled around the world last week, bond funds remained solid once again. They continued to inch ahead, while stock indexes swung up and down by more than 1 percent for five straight days. So many investors poured money into bonds in search of safety that the yield on the 10-year Treasury note temporarily dropped below 2 percent for the first time in more than a year. Yields for bonds drop when demand increases and their prices rise.
It's a reminder of the value of bonds in a diversified portfolio. But it's also important for anyone moving into bonds to keep expectations in check following their decades-long run of strong returns. Yields are lower, risks are higher and it may be difficult for bonds to replicate the returns they've produced this year. Here's a look at what to expect:
— BOND FUNDS MAY MAKE MONEY IN THE NEXT YEAR, BUT NOT MUCH.
Many bond funds have returned about 5 percent this year. Managers call that a good year, even though it would rate as a ho-hum return for stocks.
The reason is that bonds don't pay much interest. Many bond funds benchmark themselves against the Barclays U.S. Aggregate index, and it has a yield of 2.15 percent. That's down from 2.50 percent at the start of the year, and it's roughly half of what it was a decade ago.
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Bond funds have benefited from a drop in interest rates this year. When that happens, it makes the yields of existing bonds more attractive and pushes up their value. So bond fund investors get returns both from payments made by the bonds and from rising prices for the funds.
Over the next 12 months, interest rates are unlikely to drop much further, says Roger Bayston, senior vice president of Franklin Templeton's fixed-income group. That means returns for bond funds will come mostly from their interest payments. The 10-year Treasury note's yield is below 2.3 percent, but riskier bonds from companies with poor credit ratings can offer yields of about 6 percent.
Bayston is a manager atop the $4.9 billion Franklin Total Return fund, which invests in a wide range of bonds from Treasurys to foreign bonds to high-yield "junk" bonds. Bayston says he's still finding opportunities, including in mortgage-backed securities backed by agencies such as Ginnie Mae.
— BOND FUNDS ARE MORE STABLE THAN STOCKS, AND WILL LIKELY CONTINUE TO BE ...
An example of that stability is the last month. The average intermediate-term bond fund, which forms the core of most bond portfolios, has returned 1 percent. The largest category of stock mutual funds has lost 3.7 percent over the same time.
Bonds are promises by companies to repay loans with interest. As long as companies don't default, bondholders will get their promised money. And default rates are low due to how much cash companies are holding, how quickly their earnings are growing and how low their interest payments are.
"If you have a five-year bond, five years from now, you will have cash whether you want it or not," says Jeff Moore, co-manager of Fidelity's $16.1 billion Total Bond fund. "If you own a stock, five years from now, you have the stock."
In the last 30 years, the Barclays U.S. Aggregate index has had a loss just three times. The worst was a drop of 2.9 percent in 1994. Compare that with the Standard & Poor's 500 index, which lost 37 percent in 2008.
Because losses for the bond market are milder than for stocks, it gives investors an opportunity to rebalance their portfolios during down markets, Moore says. "If the stock market is down 50 percent, and bonds are down 10 percent, that's a home run for you" because investors can sell their more resilient bonds to raise cash in hopes of buying low on stocks.
... BUT PROBABLY NOT AS STABLE AS THEY HAVE BEEN.
"Everything has been a winner the last two to three years," says Gareth Isaac, a manager atop the Schroder Global Strategic Bond fund. Whether high quality or low, bonds have been rising as the Federal Reserve has kept the accelerator floored on stimulus for the economy.
But the central bank is expected to end its bond-buying program, which was purchasing as much as $85 billion monthly, next week. The economy has been improving, and economists expect the Fed to begin raising short-term interest rates late next year.
A rise in rates would mean newly issued bonds offer higher interest payments, but it would also knock down prices for existing bonds. That will mean more volatility in the bond market, with clear winners and losers emerging, Isaac says. It will mean the end for the everything's-rising market.
The question is how high rates will go, and how quickly. If it's a slow, steady rise, managers say the bond market can stay relatively stable. That's what happened from 2004 through 2006, when the Fed raised rates 17 times, and intermediate-bond funds generated an annual return between 1.8 percent and 4.2 percent.
A quick surge in rates would do more damage, whether due to a spike in inflation or another cause. Some managers, including Isaac, think pressure that is slowly building to push up workers' wages could lead to more inflation. But a sharp drop in oil and other commodity prices has been offering a counterweight.