Mutual Fund Research Newsletter
http://funds-newsletter.com
Copyright 2010 Tom Madell, PhD, Publisher
Dec. 2010. Published Nov 21, 2010

Bonds: What the Future May Hold

By Tom Madell

Notwithstanding the past few weeks, the returns on almost all types of bonds funds over the last decade have been better than many would have expected. For example, here are the 10 yr. ann. total returns on all of the specific bond funds included in our latest (Oct.) Bond Model Portfolio:

Fund
(Symbol)
10 Yr Annualized Return
Vang. Tot. Bd Mkt
(VBMFX)
6.0%
PIMCO Total Return Instit (PTTRX) 7.8
Vang. Interm. Term Tax-Exempt (VWITX) 4.6
(no Fed. taxes)
PIMCO Real Return Instit (PRRIX) 8.0
T Rowe Price Intl Bond (RPIBX) 7.7
Vang. ST Investment Gr. (VFSTX) 4.8
Vang. LT Investment Gr. (VWESX) 7.5
Vang. High Yield
(VWEHX)
6.4

Note: Results thru Nov. 19

Aggressive bond investors likely have seen even higher returns. For example, emerging markets bond funds have averaged 11.8% per year over the above 10 year period while a "zero coupon" Treasury bond fund such as American Century 2020 (BTTTX) has returned 8.6.

These types of funds, whose results were not as high, for the most part, as investors might had hoped for as compared to their former expectations for stocks, did prove to be valuable portfolio components since stocks obviously had a subpar decade. So, for example, the S&P 500 Index has returned only 0.6 over the above period. Cash, as represented by the average MM fund was a poor second at about 2.0.

And, once again looking past the past few weeks, bond gains have generally picked up even more over the last year than their 10 yr. averages. But what's past is past. The question for today is can investors in bonds continue their chant of "We're number 1" over the next few years?

As can be seen from the data above, there has been a good deal of variation in the size of returns depending which type of fund (and specific fund within its category) one chose. Of course, this will always be the case, just as there will always be variations in stock fund results depending on such choices. So it pays to think not just in terms of bond funds in general, but which ones one should focus on. So, for example, over the last decade, it would be safe to say that longer term bonds have done a little better than shorter term ones, and high quality bonds have done better than lower quality ones.

We address which specific bond funds we recommend in our quarterly Bond Model Portfolios; see our above referenced Oct. Newsletter for our latest suggestions. In this article, we will give our overall appraisal of the bond market.

Current Bond Market Prospects

In a nutshell, we do not expect bond funds to keep up the above pace over the next few years. Here's why.

Caveats

Of course, not everything is bleak for bonds. Here a few reasons why at least some types of bonds might continue to do reasonably well:

  • As "baby boomers" continue to age and begin their retirement, many of the boomers' current stock investors will wish to ensure a more stable and reliable source of income for their non-working years. Stocks, especially over the last decade, certainly have been far too volatile to consistently provide the resources needed to live off in retirement. This may be part of why data show that since early 2009, investors have added significantly to their bond fund positions while greatly reducing their ownership of traditional stock funds, even as stock funds have enjoyed a strong bull market over that period.

  • Of course, while QE2 may not result in a long-term plus for most bond prices, it may have a positive effect over the shorter term. After all, by purchasing around 900 billion dollars worth of Treasuries, mostly intermediate maturity ones including the approximate $300 billion previously announced, the Fed is, in effect, increasing the demand side of the supply/demand equation. Thus, assuming supply remains constant, which is expected, this ordinarily would have the effect of raising the purchased bonds prices (and lowering long-term interest rates.) Indeed, Chairman Bernanke states that lower rates are a goal of QE.

    But here is a conundrum: Another Fed goal is to raise inflation from near rock bottom levels. But is rising inflation consistent with a lowering of long-term bond yields? It appears that the only way for the two conditions to be so related is with a lag over time.

    Normally, long-term bond yields move in the same direction as the rate of inflation. This suggests that if the Fed is successful in lowering interest rates over the shorter term, inflation may continue to be low until such time that the economy becomes stimulated to such an extent that inflation (and interest rates) do begin to rise. When might this happen (if it does happen at all)? No one, even the Fed, can profess to know the answer, but this would seem to require a drop in inflation first before it might eventually be able to go up, which might well take quite a while. How else can there be both a drop in long-term interest rates and a rise in inflation?

    Planning a Course of Action

    Like all investing decisions, we do not think one should weigh the value of one asset category in isolation. In other words, whether and how much to invest in bonds should also depend on the return potential in other types of investments. If any or all of the reasons given above persuade you to move money out of bonds, the question becomes "Will I clearly be better off in non-bond asset categories?" specifically either cash, stocks, or even hard assets such as commodities.

    We would strongly argue, as we have done for quite a while, that cash simply does not appear to be a viable option. Returns on cash are likely to remain at no greater than 1% over the next few years as they have over the last 3 yrs. (Factoring in inflation, of course, means no return at all or even a negative return). The only way "investing" in cash makes sense is if you are sure (or, at least, very afraid) that other available investments will do even worse than 0!

    We do believe that investors will be better off in stock investments than in bonds over the next few years. But suppose you currently have about a 60/40 stock/ bond fund allocation. Are you willing to carry your concern about bond potential underperformance far enough that you now simply take most or all of that 40% bond allocation and put it in stocks?

    Except for either a) the most confident of investors, or perhaps b) relatively young investors who may have temporarily parked some money in bonds because of now greatly diminished fears of a double dip recession, we think that it is simply not justified to bolt out of most of one's bonds just because there may be a further trimming down of the formerly good returns lying ahead.

    While bonds may lose some of their luster, it must be remembered that they will continue to provide an element of safety in an investment world that will remain far from certain.

    As we have previously maintained, we expect the average bond fund to likely return an average of approximately 2.5 to 4.5% per year over the next several years. Stock funds, on the other hand, could according to our estimates, return on average about 6 to 8% per year. Given that no prediction can be counted on, and that there could be some higher bond returns or lower stock returns outside these ranges, we would recommend that moderate and conservative risk investors, especially those close to or in retirement, maintain a healthy commitment to bonds. We will update our recommended percentage allocations to stocks, bonds, and cash in our Jan. Newsletter.

    Can a case be made for investing in commodity funds? Perhaps, but we generally tend to avoid such investments because they seem too volatile, unpredictable, and pay no dividends.

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    Note: There will be no article by Steve Shefler this month.