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After a wild and profitable ride, bonds can still provide safety


UNPREDICTABLE is the norm for bonds right now.

Consider the record of the last couple of years. Bond returns suffered in 2018 as interest rates rose, and many experts bet that rates would stay at lofty levels.

But in 2019, the bond market has defied expectations: Rates have plunged for much of the year, while bond returns have soared.

With interest rates already low, further big gains are improbable. But bonds are still likely to deliver on their crucial role as portfolio stabilisers when stocks fall. Expect protection, not big profits.

It has been easy to overlook bonds' calming properties lately.

In recent months, they have gotten attention as profit generators, not as havens of stability. Core bond portfolios such as the Vanguard Total Bond Market Index fund and the iShares Core US Aggregate bond exchange-traded fund gained more than 12 per cent from early last November through the first week of September, a period when the yield on the 10-year Treasury note fell to below 1.5 per cent from above 3 per cent.

If you're not a bond maven, it's worth remembering that fund and ETF returns are the sum of the interest earned on the bonds and the changes in the prices of those bonds. When interest rates fall, bond prices rise. That's why the slump in rates unleashed big price gains in 2019 - and why a rise in rates would hurt bondholders.

As a consequence of the twisting currents in the bond market, playing it safe turned out to be a lucrative strategy this year. In normal times, investors who own short-term bonds earn less interest than investors who own long-term bonds. But these are not normal times.

Short-term rates haven't fallen as much as long-term rates, creating an inverted yield curve, where shorter-term Treasury rates are higher than longer-term ones. Those relatively higher yields, along with small price gains, generated a return of more than 4 per cent this year, more than double the rate of inflation.

Don't count on rewards like that continuing for much longer.

"The road ahead gets that much more difficult because you are now buying more bonds at lower yields," said Tom Atteberry, manager at FPA New Income, a fund that aims to provide a return that is at least one percentage point above inflation over five-year periods, with no annual losses. Mr Atteberry says that will be difficult to achieve, now that most Treasuries yield less than the rate of inflation.

Moreover, the outlook is especially cloudy, several experts said.

"You have a very dangerous bond market from a risk perspective," said Daniel Ivascyn, manager of the Pimco Income fund, the largest actively managed bond fund, with US$130 billion in assets. "Although yields could go lower, they could also go a lot higher." If interest rates rose one percentage point, core bond funds that track the Bloomberg Barclays US Aggregate Bond Index - the default benchmark used in bond funds popular in 401(k) retirement plans - would lose about 6 per cent in price. The index's low yield of around 2.2 per cent would provide scant cushion. If rates rose more, losses would be larger.

With "heightened uncertainty" as a driving theme, Mr Ivascyn and his co-managers, Alfred Murata and Joshua Anderson, have taken a more defensive approach with Pimco Income over the last year. As a result, the fund wasn't able to reap big price gains as rates fell, and it has had a light weighting in domestic corporates, which have had a ferocious rally.

But the Pimco team expects mortgage bonds to hold up better than corporate bonds if the economy weakens. That is because the housing market, in their view, has been fortified by increased regulation since the last financial crisis, while corporate bond risks have been rising.

Pimco Income's 5.7 per cent gain in 2019 is more than one percentage point lower than the average return for core bond funds tracking the Bloomberg Barclays US Aggregate Index. The fund has gained 167 per cent since its 2007 start, compared with 68 per cent for the index.

Current issues like the tariff conflict have contributed to bond market unpredictability, but there are other, less obvious problems.

One longer-term structural concern is the possibility that "we are headed in the same direction" as Europe and Japan, says Chris Brightman, chief investment officer at Research Affiliates.

Ageing populations clamouring for bonds, combined with low economic growth, have contributed to a drop in government bond yields in those developed economies into negative territory. Central banks have been unable to stimulate growth and inflation, which would be expected to push bond yields upwards.

The United States is still far from negative nominal rates, but with yields at their current low levels, bond portfolios may not earn enough to keep pace with inflation.

Mr Atteberry at FPA said that even though yields from Treasury bills and other money-market instruments stack up well against longer-term bonds now, piling into Treasury bills will only postpone your problems. "You are paid 1.9 per cent for three months, but what about the next three months, and the three months after that?" And while money managers insist that low-yielding Treasuries are too expensive, Jonathan Guyton, principal at Cornerstone Wealth Advisors in Edina, Minnesota, suggested that people near or in retirement need to remember why they own bonds.

"Yes, we are looking for bonds to contribute some element of return, but what we most need bonds to do is not go down when equities go down," Mr Guyton said. "Treasuries are the most reliable way to do that." Mr Guyton has done research on how much can be safely withdrawn from retirees' portfolios. He has found that withdrawals can start a bit above the traditional 4 per cent safety threshold, assuming retirees have the flexibility to scale back in rough markets and follow certain other rules.

For a safely diversified portfolio, he says, intermediate Treasuries - generally those with a duration of two to 10 years - typically provide the best bond counterweight to falling stocks.

For instance, during the rough market for stocks that ran from early September to late December last year, the Schwab Intermediate-Term US Treasury ETF gained 2.5 per cent compared with 1.2 per cent for the Schwab Short-Term US Treasury ETF. The Schwab US Aggregate Bond ETF gained 1.5 per cent.

If you value the ballast that high-quality bonds provide, holding them still makes sense. But amid expectations of paltry returns, it may be wise to rethink your personal strategy.

"You should consider, at the margin, working a little longer than you planned, saving a little more than you originally thought necessary, and then maybe living a little more frugally in retirement," Mr Brightman at Research Affiliates said.

That may not be upbeat advice. But changing your plan, not your portfolio, could be a smart way of coping with a low-return world. NYTIMES

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