Bond funds trouncing stocks, but will it last?
For Banc One Investment Advisors, August 2001
(from http://www.onegroup.com/readingroom/bondoutpace1.asp)
When the stock market was booming in the late 1990s, many small investors regarded bond funds as something only for the ultra-cautious – retirees, 50-something couples saving for their golden years. The market of late has shown this concept might no longer be true.
Bonds have trounced stocks over the past year, and taxable bond funds outperformed the Standard & Poor’s 500 index by a solid 24 percent over the past 12 months, according to fund-tracking firm Morningstar. All of a sudden, people are starting to listen to the pundits who have argued for years that everyone should have at least a small percentage of bonds in their investment portfolios.
The rally in bond funds may still have another good year in it. Traditionally, bonds do better than stocks during periods of economic slowdowns or slow growth, and of declining interest rates. The economy, while it may avoid a recession, doesn’t show any signs of the heady growth that was the norm during the 1990s. Plus, Alan Greenspan has indicated the Fed may still have another rate cut or two up its sleeve, which could extend the returns on bonds and bond funds, at least through the end of the year.
“I think there is some more room to run,” says Diane Vazza, managing director for global fixed income at the rating agency Standard & Poor’s. “Certainly in terms of diversification, it’s (still) a good time to go into a bond fund.”
To be sure, bonds won’t outperform stocks forever. Over the past 10 years, stocks have outperformed bonds by an average of more than 7 percent a year. And in the history of the mutual fund industry, bond funds have never beaten stock funds for more than two years in a row. However, they have had some good, strong runs. For example, after handily beating stock funds in both 1981 and 1982, bond funds went on to post four more straight years of double-digit returns.
The key to today’s bond market is the Federal Reserve. The Fed has cut interest rates six times so far this year, and many economists expect another rate cut later this month (August). When the Fed cuts rates, already-issued bonds become more valuable because newly issued bonds have lower yields. If the Fed reverses course and starts to raise rates, the reverse will be true and the difference in yield between new bonds and most existing bonds will narrow.
But performance isn’t all that counts. Bond funds aren’t as volatile as stock funds, and volatility has a price. Stocks have never been more volatile than they are now. What that means for the small investor is that, unless you time all your buy and sell orders perfectly, you could end up under-performing the stock market. And if history is any guide, the stock market is likely to post significantly smaller returns over the next decade than it did over the past 10 years.
With most bond funds, while the returns are far from guaranteed, the risk of sharp losses is much less. To gauge just how risky a bond fund is, investors should look at readily available data such as interest rate sensitivity, credit quality and the average maturity of the bonds the fund holds (longer maturities tend to be more volatile than shorter maturities).
Low volatility is especially important for anyone planning to withdraw the money in the near future. Retirees, for example, should pay more attention to volatility than investors in their 20s, for example, because retirees probably need to get at the money sooner.
Bond funds also tend to pay more income than stock funds – another characteristic that makes them attractive to retirees.
So, what type of bond fund is best for you?
It depends in part on what type of investor you are, and what type of account you are investing in. If the fund is in an IRA or a 401k, you don’t need to worry about taxes, so municipal bond funds probably aren’t a good bet because their pre-tax returns tend to be less than corporate bonds or Treasuries. On the other hand, if your account status is taxable, tax-free municipal bonds might offer the best total returns for you, especially if you’re in a high tax bracket.
Next, find out what type of investor you are and your tolerance for risk. To help, use One Group’s online asset allocation planner. After answering several questions, you’ll see a pie chart such as the one below, with suggested allocations for cash, bonds and stocks, based on your individual investment goals and risk tolerance.
Among taxable bonds, different categories offer different yields, different levels of risk and different cost structures. High-yield bond funds, sometimes referred to as “junk” bonds, have beat almost all other categories over the past decade in average annual returns, but they are highly volatile and more costly. Over the past year, for example, high-yield bond funds have lost 6.47 percent while virtually all other categories of bond funds have posted positive returns.
“If you want to take on more risk and get more pop, I think high-yield might be the place to be. At today’s yields, you are being compensated for the default risk,” says Vazza. “And high-yield certainly holds a place in the fixed-income portion of your allocation.”
For the average small investor, however, investment-grade corporate and government bond funds are probably the first and safest place to put your bond allocation. In addition to providing strong long-term returns and the security of low default risk, these bond funds also provide a cushion to your overall portfolio because they display low correlation with both the stock market and economic growth. In other words, when both the stock market and the economy are slowing, investment grade bonds tend to do well.
The question then becomes which maturity category is best: short-term, intermediate or long-term. As the table below shows, long-term and intermediate term have outperformed short-term bonds over both the one-year and 10-year time periods. However, short-term bond funds tend to have less volatility.
If you already own a few domestic bond funds and are looking to diversify your portfolio further, international bond funds or even emerging market bond funds offer attractive alternatives. Again, investors should pay attention to both risks and returns. The yields on emerging market bonds tend to be higher than U.S. bonds, for example, but because of the risk of defaults, funds that invest in these bonds might actually see lower total returns.
In sum, bond funds, while not as exiting as growth stocks, are an essential part of mostportfolios. And, if done right, investing in them can give a needed boost to your returns while also providing diversification to limit possible losses.