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The bond investing free lunch is over

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


BONDS lived down to expectations last year. The threat of rising interest rates, which had lurked in the ether for five years, finally materialised, 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 US Aggregate bond index, the benchmark for high-quality taxable bonds, lost 2 per cent, registering only the third negative calendar-year performance since 1976, where the index's data starts.

Investors took notice. From June till mid-December, bond funds had net outflows of more than US$155 billion, according to the Investment Company Institute. Investors in Pimco Total Return, the largest bond mutual fund, have withdrawn more than 10 per cent of assets from the fund since the rate rise began, according to Morningstar. Net outflows from Pimco Total Return's exchange-traded fund (ETF) counterpart have exceeded 15 per cent 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 US$745 billion in bonds, said that investors need to "re-anchor their expectations" to annualised returns of 1.5 per cent to 2.5 per cent over the next decade. At best, that would be just half the annualised gain that the Vanguard Total Bond Market Index fund delivered over the past 15 years.

It is 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 mathematics is now reversed. With rates still low and expected to rise as the Federal Reserve pulls back its stimulus, there is 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 "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 US Aggregate down about 5 per cent before it rebounded. And the 2 per cent 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 said that less than 15 per cent of bond fund assets are held in such portfolios.

More yield in investor pockets

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 annualised return over that period was a positive 4.5 per cent.

"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 ETF lost 21 per cent. The high-grade iShares Core Total US Bond Market ETF, which tracks the Barclays US Aggregate index, gained nearly 5 per cent 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 is not an ideal moment for junk bonds: While the 6 per cent 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 per cent to own a junk bond maturing in eight years, I'd do it," said Carl Kaufman, a manager of the Osterweis Strategic Income fund. "But 6 per cent is not worth the risk."

Mr Kaufman said that the fund is now content to accept the lower yields of 5 per cent 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, suggested 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 per cent of its bonds invested in high-grade issues, and the remaining 20 per cent in high-yield.- NYT