Surprise: Bond funds are doing just fine.
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After turning in their worst quarterly performance in years, bond funds were supposed to keep struggling as the calendar flipped to 2017. Managers were busy early this year making sure expectations were properly low for bond funds, even after billions of dollars left them in November and again in December.
But reality, at least so far, has turned out to be nearly the opposite of expectations. Rather than continuing to drop, bond prices have perked higher this year. That's helped funds focused on intermediate-term U.S. government bonds return an average of 1 percent through the first third of the year, more than they have in three of the last four full years. Returns have been better for funds that add in corporate bonds, which have higher yields than Treasurys.
The turnaround for bond funds, which serve as the safe corner of most 401(k) accounts, is only the latest example of predictions for the death of the bond market being premature. And investors have returned to them. More than $100 billion flowed into bond funds during the first three months of 2017, double the pace of last year's start, according to the Investment Company Institute.
But it's important to keep expectations for future returns in check. Today's low rates mean bonds are producing less in income. And despite what's happened this year, virtually everyone agrees that prices for bonds are more likely to weaken than to rise in upcoming years. That's because bond prices move in the opposite direction of their yields, and most everyone expects yields to rise, eventually.
Bond funds got slapped last November by a swift rise in interest rates after Republicans swept the White House and Congress. The thought was that tax cuts, a big infrastructure spending package and other changes in Washington would lead to faster economic growth, higher inflation and increased borrowing by the federal government. Each of those tends to push rates higher, and thus bond prices lower. The yield on the 10-year Treasury jumped above 2.60 percent by mid-March from 1.85 percent on Election Day.
But rates began sinking shortly thereafter. One big reason: Republicans' difficulty in overhauling the health care system, something they had been promising to do for years. The market's thinking flipped to: If they have trouble with that, maybe tax cuts, infrastructure spending and the other potential changes that drove up rates wouldn't happen.
Longer-term interest rates tend to correlate with expectations for economic growth and inflation, and the 10-year Treasury yield has fallen back to 2.35 percent.
THE SPLIT OPINION
While the bond market's expectations for economic growth have ratcheted back, stock investors are still optimistic and the Standard & Poor's 500 index remains close to its record high. It's a dichotomy that's drawing more attention.
Erin Browne, head of macro investments at UBS Asset Management, leans more to the stock market's side.
"Yields are too low based on the pickup we're starting to see in the economy," she said. "People largely right now are buying bonds at the wrong time."
Browne doesn't think rates will go back to where they were before the Great Recession, when the 10-year Treasury had a yield of more than 4 percent, for a while. But she does expect them to rise because economies around the world finally seem to be in sync and moving forward.
"This is the first year, really since the global financial crisis, where you have all countries contributing to global GDP growth," Browne said.
A SLOW CLIMB
William Irving, who manages the $4.3 billion Fidelity Government Income fund, also forecasts rates will rise, but only at a very measured pace. He expects the 10-year yield to stay below 3 percent for the near term because he sees economic growth remaining on a slow course.
"We're in an environment with aging demographics, lots of debt, income inequality and excess capacity," he said. "All these are supportive of low growth, and low rates go hand in hand with low growth."
He acknowledges that the bond market faces many risks that could push rates higher, such as the possibility of Washington coming together on a big stimulus program or of inflation jumping higher, which would push the Federal Reserve to raise interest rates at a quicker pace. Rates could also rise as the Fed begins paring down the $4.5 trillion it owns in Treasurys and mortgage bonds.
Even with all that, Irving asks investors not to give up on bonds.
"You look back since the crisis, there have been many wrong-footed calls that we're in a rising rate environment, and you should just hide out in short-term bonds" he said. "It's tough to time, and I think it's better to have a long-term strategy and just accept that we're likely in a low-growth world, which is going to keep a lid on yields."