In the Bond Market, Lower Expectations Became the Reality; The bond investing free lunch is over; Rising interest rates have pushed prices lower, sending total returns into negative territory

In the Bond Market, Lower Expectations Became the Reality

The bond investing free lunch is over

Rising interest rates have pushed prices lower, sending total returns into negative territory

By CARLA FRIEDJAN. 10, 2014

BONDS lived down to expectations last year. The threat of rising interest rates, which had lurked in the ether for five years, finally materialized, pushing prices lower.That sent total returns — the combination of yield and price changes — into negative territory, as low yields provided little cushion. The Barclays U.S. Aggregate bond index, the benchmark for high-quality taxable bonds, lost 2 percent, registering only the third negative calendar-year performance since 1976, where the index’s data starts.

Investors took notice. From June through mid-December, bond funds had net outflows of more than $155 billion, according to the Investment Company Institute. Investors in Pimco Total Return, the largest bond mutual fund, have withdrawn more than 10 percent of assets from the fund since the rate rise began, according to Morningstar. Net outflows from Pimco Total Return’s exchange-traded fund counterpart have exceeded 15 percent of assets.

The slump last year is very likely just the first chapter in a story that will play out for years. Joe Davis, head of the investment strategy group at Vanguard, which manages nearly $745 billion in bonds, says investors need to “re-anchor their expectations” to annualized returns of 1.5 percent to 2.5 percent over the next decade. At best, that would be just half the annualized gain that the Vanguard Total Bond Market Index fund delivered over the past 15 years.

It’s the end of the bond-investing free lunch. Anyone who came of investing age since the early 1980s — when rates peaked — could own bonds for their risk-damping ballast when stocks tanked, but could also earn a nice total return as yields fell and prices rose. The math is now reversed. With rates still low and expected to rise as the Federal Reserve pulls back its stimulus, there’s not much room for rates to fall and prices to rise.

“Bond returns don’t look incredibly attractive, but you have to remember why you own them,” said Gary Schatsky, president of the planning firm ObjectiveAdvice.com. “For most investors, it’s the shelter they provide when stocks slide.”

He added, “Owning bonds helps us lose less in bad markets.”

Moreover, talk of carnage in a bond bear market appears a bit exaggerated. At its worst, this year’s sell-off pushed the Barclays U.S. Aggregate down about 5 percent before it rebounded. And the 2 percent loss for the entire year would count as just a single bad day for stocks. Rising interest rates have a greater impact on the price of bonds with long maturities, and to be smacked with double-digit losses in high-quality bonds when rates spike, you would have to be holding issues that mature in 10 years or more. Morningstar says that less than 15 percent of bond fund assets are held in such portfolios.

While a climb in rates pushes bond prices down, it also sends more yield into investor pockets. Over time, that higher income can offset price declines. The fixed-income team at the Schwab Center for Financial Research, looked at how bonds fared from 1954 to 1981, which it considers the last bond bear market. Intermediate-term government issues had five negative calendar years in total return during that stretch, but the annualized return over that period was a positive 4.5 percent.

“Not too bad for a bear market,” the bond analysts dryly noted in their report.

THE picture is different for the high-yield or junk segment of the bond market, where inflows have been strong the past few years. High-yield bonds are not very sensitive to rising rates and are likely to do well this year if the economy continues to gather steam. But in recessions, they earn their “junk” nickname. In 2008, the SPDR Barclays High Yield Bond E.T.F. lost 21 percent. The high-grade iShares Core Total U.S. Bond Market E.T.F., which tracks the Barclays U.S. Aggregate index, gained nearly 5 percent that year.

“Given the risk of junk, I’d just rather own stocks, since that’s what they resemble in down markets,” said John Rekenthaler, vice president for research at Morningstar.

In some respects, it’s not an ideal moment for junk bonds: While the 6 percent yields of today are much more than what Treasuries or high-grade corporates pay, they nonetheless represent a steep drop from the double-digit yields of a few years ago.

“If I was getting paid 10 percent to own a junk bond maturing in eight years, I’d do it,” said Carl P. Kaufman, a manager of the Osterweis Strategic Incomefund. “But 6 percent is not worth the risk.”

Mr. Kaufman says the fund is now content to accept the lower yields of 5 percent or so from short-term junk bonds. “We’re not getting paid enough to stretch out longer,” he said.

Mike Gitlin, director of fixed income at T. Rowe Price, suggests taking a barbell approach. “On one end of your barbell are the high-quality core bonds that often give you the negative correlation to stocks that works well when stocks decline and short-term bonds that protect you from interest rate risk,” he said. “On the other end are the lower-quality issues that give you more income.”

As a point of reference, the T. Rowe Price Retirement 2030 fund, a diversified portfolio of stocks and bonds for investors reaching retirement age in about 15 years, currently has 80 percent of its bonds invested in high-grade issues, and the remaining 20 percent in high-yield.

Allan S. Roth, founder of the investment advisory firm Wealth Logic, in Colorado Springs, whose corporate motto is “Dare to be dull,” avoids bonds altogether for his personal portfolio and those of many of his clients. He prefers five-year certificates of deposit that have lenient withdrawal penalties in the event that he finds a better investment. He currently uses the five-year C.D. offered by the Pentagon Federal Credit Union, which yields 3 percent. “I have no loss of principal, it’s federally guaranteed, and that 3 percent is more than I can earn today with a high-grade bond fund.”