Worried that interest rates could rise for years to come, some investors have been dumping their bonds. But the extreme bears are probably overreacting. Under most scenarios, bonds will deliver modestly positive returns in coming years. What sort of returns should investors expect for the next decade? To figure that out, consider a system that has long been promoted by John Bogle, the founder of Vanguard Group.
Instead of shifting allocations now to avoid soft bond markets, investors should maintain their long-term strategic allocations, says Michael Kitces, research director of Pinnacle Advisory Group, a wealth management firm in Columbia, Md. Kitces says that the main reason to hold fixed-income assets is diversification. Bonds often rise when stocks fall. Investors who abandon bonds now would have little protection if stocks crash. “It is very risky to make dramatic changes in your portfolio in anticipation of higher rates,” he warns.
Over the years, bonds have proved to be valuable diversifiers — even during periods of rising rates. Intermediate government bonds rarely have recorded more than one or two losing years in a decade. Most losses have been tiny. According to Ibbotson Associates, the biggest annual loss since 1926 came in 1994 when intermediate governments lost 5.1 percent. That year was unusual because the Federal Reserve slammed on the brakes, raising the federal funds rate from 3 percent to 5.5 percent and catching investors off guard. “The Federal Reserve shocked the system, and that caused volatility and losses,” says Christopher Philips, a senior investment analyst for Vanguard Group.
Philips says that the Fed is unlikely to administer another shock any time soon. In the past decade, the central bankers have avoided surprises, raising rates slowly and signaling the moves well in advance. As a result of the caution, the markets have adjusted smoothly, and there has been no repeat of the losses that occurred in 1994. Philips notes that the Federal Reserve raised short-term rates from 1 percent in 2003 to 5.25 percent in 2006. For investors in mutual funds, the higher rates caused share prices to soften. But the funds could reinvest bond interest at higher rates. That compensated for share losses and enabled the funds to deliver positive total returns every year during the period of rising rates.
Make no mistake, bonds are bound to deliver meager returns in coming years because of the math of the markets. As rates fall, bonds record capital gains. That happened during the past three decades. After peaking above 15.8 percent in September 1981, yields on 10-year Treasuries fell, hitting a trough below 2.1 percent in December 2008. During the period of falling rates, intermediate government bonds returned more than 8 percent annually.
Now yields are puny. Because rates can only fall to zero, the capital gains recorded by bonds will be limited. What sort of returns should investors expect for the next decade? To figure that out, consider a system that has long been promoted by John Bogle, the founder of Vanguard Group. According to Bogle, returns of the coming decade will about equal the current bond yield. He says that the forecasting system works because most of the return of bonds comes from the yield. If Bogle is right, then investors can look forward to annualized 10-year results of about 3.4 percent, the recent yield on 10-year Treasuries.
Bogle's system may seem simple, but it has proved highly accurate for decades. In January 1970, 10-year Treasuries yielded 7.8 percent. During the next decade — a period of rising rates and inflation — intermediate government bonds returned 7 percent, according to Ibbotson. In January 2000, Treasuries yielded 6.5 percent, and governments returned 6.2 percent in the next 10 years.
For a safe way to hold bonds in an era of meager results, some investors may prefer a passive fund such as Vanguard Total Bond Market Index (VBMFX), which tracks the Barclays Capital Aggregate U.S. bond index. The Vanguard fund has delivered decent results, returning 5.3 percent annually during the past 10 years and outdoing 55 percent of intermediate-term funds. But the Barclays index focuses on government issues, ignoring high-yield and foreign bonds. For greater diversification — and perhaps higher returns — it makes sense to build a portfolio that includes a wider range of bonds.
A solid choice is Janus Flexible Bond (JDFAX), which has returned 6.1 percent annually during the past decade, outdoing 84 percent of intermediate-term competitors. The Janus fund holds a mix of government and corporate bonds, varying the mix as conditions warrant. During 2007, Portfolio Manager Gibson Smith became concerned that corporate bonds had become too rich. The meager corporate yields did not compensate for the risk of default, so he put 70 percent of assets in Treasuries. The move protected shareholders as the credit crisis unfolded and corporate bonds sank.
These days he has most assets in corporate bonds. Smith figures that the economy will continue strengthening, and rates will rise a bit this year. That will hurt Treasuries, but corporate bonds should prosper because they have competitive yields and strong balance sheets. Though he is not bullish on government issues, Smith has 30 percent of assets in Treasuries. “The weighting in Treasuries gives us insurance against some unforeseen event,” he says.
To diversify a high-quality portfolio, consider adding high-yield funds, which invest in bonds that are rated below-investment grade. High-yield bonds currently yield about 7 percent. During periods of a strong economy and rising rates, high-yield bonds can appreciate as investors worry less about default risk. A solid fund is Janus High-Yield (JHYAX), which has returned 7.2 percent annually during the past 10 years, outdoing 52 percent of competitors. The Janus fund is a relatively conservative high-yield fund, avoiding shakier bonds with the lowest credit ratings.
For additional diversification, consider adding an emerging markets bond fund. Emerging funds cratered in 2008, but they have come roaring back. In 2010, the funds returned 12.2 percent, outpacing the Barclays Capital U.S. benchmark by eight percentage points.
A solid fund is MFS Emerging Markets Debt (MEDAX), which has returned 12.9 percent annually during the past 10 years, outdoing 87 percent of competitors. Portfolio Manager Matthew Ryan limits risk by staying broadly diversified and emphasizing unloved bonds. Ryan argues that emerging bonds are on relatively firm footing. While developed countries struggle with heavy debt burdens, many countries in the emerging markets are in sound financial shape. Solid emerging bonds yield more than 6 percent. “Emerging market bonds look reasonably valued compared to high-yield bonds or other assets,” says Ryan.