Don't expect much from your bond mutual fund next year.
The bond market will likely produce modest returns, if they're positive at all, according to many bond-fund managers. It's a matter of math: Bonds are offering very low interest rates following a decades-long drop in yields. That means they're producing less income.
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It also means bonds have less protection from rising interest rates. When rates climb, the price for existing bonds falls because their yields suddenly look less attractive than those of newly issued bonds. If bonds were yielding 8 percent or 10 percent, they could more easily make up for a decline in price with their interest payments. But a 10-year Treasury note offers a yield of just 2.24 percent. Less income coming in means it takes a smaller price decline to saddle bond investors with losses.
"We're getting to the point where it's really dangerous," says Bill Eigen, manager of the JPMorgan Strategic Income Opportunities fund. He says he's the most nervous about the prospect of rising rates that he's been in his career.
Investors got a taste of what bond losses feel like last year, when the average intermediate-term bond fund fell 1.4 percent due to a rise in rates. It was the biggest loss for the bond market in nearly two decades. Mangers say that, at the very least, it's best to prepare for big swings in bond returns next year.
To be sure, many managers predicted bond losses a year ago, and they were wrong. Interest rates unexpectedly fell, and this year the average intermediate-term bond fund has returned nearly 5 percent.
But even the more optimistic bond fund managers say returns will likely be lower in 2015. Virtually all economists expect the Federal Reserve to raise short-term interest rates in 2015, which would be the first increase since 2006. The central bank has already ended its bond-buying stimulus program, shuttering it in October.
"Given where bonds are, you should not be thinking about a return like this year," says Matt Freund, chief investment officer of USAA mutual funds. "It could happen, but I wouldn't want to base my financial plan on it."
Here are some questions set to shape the bond market in 2015:
— RATES ARE RISING, RIGHT?
Nearly everyone is planning for the Fed to raise rates next year because the economy may have finally caught enough momentum. The unemployment rate hasn't been this low since 2008, and the economy just delivered its strongest back-to-back quarterly growth since 2003.
Many fund managers forecast the Fed will begin raising rates in mid- to late-2015. It has kept the federal funds rate at a range of zero to 0.25 percent since 2008.
— BUT MAYBE NOT TOO MUCH?
Even though the economy is improving, it's still fragile. That could lead the Fed to move more slowly in raising interest rates than many investors expect, says USAA's Freund.
Inflation also remains low, with the price of oil close to a four-year low and the dollar at its strongest level in years. That gives the Fed more leeway to take its time in raising rates.
The yield on the 10-year Treasury could be around 2.5 percent at the end of 2015, says Joe Davis, Vanguard's global chief economist. That's only a little higher than its current yield, and Davis expects the taxable bond market to return 2 percent to 3.5 percent annually over the next several years.
— AREN'T SHORT-TERM BONDS SAFE?
Long-term bonds lock investors into yields for a longer time period, so rate increases can hurt them more than short-term bonds. That's pushed many investors to pile into short-term funds, hoping to reduce their risk.
The $22 billion that they put into short-term bond funds over the last year is 10 times what they put into intermediate- and long-term bond funds, combined, according to Morningstar.
But short-term bond investors aren't getting a free lunch, says Karl Dasher, co-head of fixed income at Schroders. Yields are so low that they're in danger of losses when the Fed begins raising short-term rates.
Longer-term bonds may actually be in a better position, Dasher says. Long-term rates may not rise as much for several reasons. Pension funds and other big institutional investors will continue to buy long-term bonds to cover their liabilities, for example, and that demand should help to support prices for longer-term bonds.
— WHAT ABOUT CREDIT RISK?
Interest rates have been so low that investors searching for yield have reached into areas they may have avoided before.
Junk bonds, for example, are issued by companies with poor credit ratings. They pay higher yields to attract investors, but they're riskier. Default rates have been low recently and are expected to remain so.
But prices for junk bonds can swing more widely than others, and volatility looks set to rise with interest rates. The fear is that many of the newbies in the junk-bond market will rush to sell at once, which could cause even sharper price declines.