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A Bear Market for Bonds? Don't Bet On It

Abandoning bonds in favor of stocks might appear sensible — but risky.

The consensus among market watchers is that bond prices are headed nowhere but down. As a result, your clients may want you to overweight their portfolios in stocks.

But wait. Had you followed that then-conventional wisdom in September 1999, you might have dumped bonds, which from then until the end of March this year, rose 21 percent. Stocks, measured by the Russell 1000, fell 8.5 percent.

True, the arguments to lighten up on bonds do sound compelling. The recession appears to be over, so rates likely will rise and, of course, rising rates mean lower bond prices.

Also, bond pessimists might point out that only twice since 1926 have bonds outperformed stocks three years running. They now have done so for two years.

So, what's the case for bonds now?

For one thing, the argument that interest rates are low and can only go up is not accurate — at least not for all rates. While the Federal Funds rate dropped from 6.5 percent to 1.75 percent over the past year, and the two-year Treasury rate fell 1.5 percentage points to about 3.5 percent, the 10-year Treasury bond is a better proxy. And rates have, if anything, risen slightly over the last 14 months. The recent 10-year Treasury rate — above 5 percent — is historically high, judged by the long-term record since 1926. There have been periods — even long stretches — when 10-year rates have been much lower. Long bond yields remained under 4 percent for 32 years, from 1926 to 1958.

Of course, monetary policies were different then and the U.S. was tied to the gold standard, but a similar low-inflation scenario in the future is not impossible, and that could mean a further fall in yields.

What's more, returns of stocks and bonds may not be that different. Many strategists predict equity returns at 5 percent to 10 percent a year over five years. Bond market returns might not be so much different. Estimates for the same period, barring any huge change in rates, can be based on the recent yield-to-maturity on broad indexes such as the Lehman Brothers Aggregate, which recently stood at 5.6 percent.

Furthermore, a bull market for stocks is not a sure thing.

Even now, stocks are highly valued by some metrics. Also, consumers are awash in credit card debt, which would dampen the economy if they were forced to curtail spending; corporations are facing a credit crunch; and there are serious continued concerns over corporate earnings. Historically, bonds have shown a low correlation with stocks, which — assuming the pattern holds — means that if stocks slump, bonds are likely to perform relatively well.

In devoting a portion of their portfolios to bonds, investors should consider diversifying. Should the economy improve and the Federal Reserve tighten, Treasurys likely will suffer most. Under a rising Federal Funds rate, it would be best to be in corporate bond funds that allow small positions in non-investment grade corporate bonds. Mortgage-backed bonds had a great run-up in the first quarter, but such gains might not continue. Those who manage the Russell funds find better value in investment-grade corporate bonds than in high-yield names. Asset-backed bonds have a short duration and investors would be taking an interest-rate bet that smacks of market timing should they bulk-up on such issues.

Therefore, investors should seek diversified bond funds that are spread among a variety of sectors (see page 63), including investment-grade bonds and BBB-rated corporate bonds.

Selection of such bond funds will provide good diversification and may well provide a decent return on a risk-adjusted basis. Doing so does not ensure a profit or protect clients from a loss, but it helps your client to be ready whatever happens.

Writer's BIO:
Jeff Hussey manages multimanager fixed income portfolios for Frank Russell Co.

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