Growing Baby Boomer Demand May Depress Bond Yields, Boost Principal

Randy Bateman of Orlando, Fla., is buying more bonds as he gets older. At age 50, bonds comprise about 38% of his investment portfolio, while 10 years ago all he owned was stocks.

He figures that about 75% of his portfolio will be in fixed-income securities when he’s 65.

Demand from aging baby boomers such as Bateman may significantly affect the outlook for bond investments in the years ahead, some experts believe. Stronger demand could lead to lower yields on new bonds--and sharply boost the principal value of older bonds.

The first of the 75 million baby boomers, who comprise about 27% of the U.S. population, will turn 55 next year.

“We’ve had a bull market in stocks, and part of it is because of the baby boom generation building up that nest egg,” said Bateman, who pays attention to such trends as a portfolio manager for SunTrust Private Capital Group in Orlando, Fla.

“The exact same thing is going to happen in bonds in the next few years as baby boomers start to retire,” he predicted.

Bonds--essentially, IOUs issued by the U.S. Treasury, companies or municipalities--generally are far more stable investments than stocks. Bonds offer the security of a fixed annual interest payment and a promise to repay the face value of the security at maturity.

Bonds aren’t for investors seeking huge capital appreciation. Rather, they offer a way to preserve capital already accumulated, barring rapid inflation.

But existing bonds can appreciate in value under one scenario: If market interest rates drop, older bonds paying higher yields naturally become worth more.

That happened in the 1980s, in fact. In the 10 years ended Dec. 31, 1990, a steep decline in market rates helped produce a 213% “total” return on the average general bond mutual fund tracked by Lipper Inc.

Total return measures the interest earned on bonds plus or minus the appreciation or depreciation of the underlying principal.

In that same 10-year period, the average U.S. stock mutual fund had a total return of 203%. So bonds actually beat stocks in that period.

But the decline in market interest rates in the 1980s was from extremely high levels in the late 1970s, when inflation was soaring. The 10-year U.S. Treasury note yielded 12.4% at the end of 1980. By 1990, the yield had tumbled to 8.1% as inflation fell as well.

Now, the 10-year T-note yield is about 6.2%. It has risen from 5.8% a year ago as the Federal Reserve has tightened credit, pushing all rates higher.

But many economists say it may be very difficult for bond yields to fall dramatically in the years ahead. And if inflation continues to accelerate, bond yields could easily surge instead of fall--leaving investors who own older fixed-rate bonds wishing they didn’t.

Inflation is bonds’ worst enemy because it eats away at fixed returns.

What’s more, many baby boomers simply find bonds boring, at least compared with stocks.

But boring can be good if the stock market is diving. Indeed, so far this year, the Pimco Total Return Fund in Newport Beach--the biggest bond mutual fund with $31 billion in assets--is up more than 2% in total return.

Many stock funds, by contrast, are down this year.

Yet mutual fund investors, on balance, continue to pour dollars into stock funds. Meanwhile, many bond funds continue to see cash flow out, even though, on a total return basis, many bond fund investors are making money.

As baby boomers age, however, some analysts believe that it’s inevitable that they will move more of their portfolios into bonds.

That’s what most financial advisors recommend. Fidelity Investments, the biggest U.S. mutual fund company, in its guide to bond funds available on the Internet, says a couple in their early 40s saving for retirement and college may consider having just 15% of their assets in bonds and the remainder in stocks.

But by their mid-60s, Fidelity says, that same couple, now retired, might be looking for dependable income to pay for their living expenses. Their portfolio might be as much as 50% in bonds, or perhaps more.

Demand for bonds may even spread beyond the United States as retiring workers from other countries look for capital-preserving securities.

“It’s generally a positive for all bond markets,” said Kevin Colglazier, director of fixed income for Asia at CMG First State Investments (Hong Kong) Ltd., which oversees $450 million of debt. “That’ll have a beneficial effect on corporate debt and what is today considered emerging-market debt.”

Of course, baby boomer demand for bonds may grow slowly. “The story is extremely powerful, but it’s not going to happen tomorrow,” Colglazier said.

Much may depend on the stock market. If returns on stocks are weak for an extended period, more investors may judge that the returns they’re getting in equities, relative to the risk they’re taking, aren’t as appealing as owning more stable bonds.

Much also will depend on what the Federal Reserve does with short-term interest rates, which it largely controls. Today, with money-market fund yields nearing 6%--not much below what longer-term T-bonds yield--many investors logically figure they’re better off preserving capital in a super-safe money fund than in a bond fund.