For bonds, middle came in last
For income-oriented investors, the formula for success last year was to take either no risk or a lot of it.
People who stayed in money market mutual funds earned an average yield of 4.5% for the year, with virtually no risk, according to data from IMoneyNet Inc.
At the other end of the spectrum, funds that owned bonds of emerging-market countries such as Russia and Brazil generated an average total return of nearly 11% for the year, as continued economic growth overseas and political stability in many regions lured investors to those high-yielding securities.
People who chose the middle ground -- say, funds that own long-term, investment-grade bonds such as top-quality corporate or U.S. Treasury issues -- had to settle for relatively paltry total returns in the 3% to 4.3% range, on average, according to Morningstar Inc.
As often is true in the fixed-income world, bond investors were at the mercy of the Federal Reserve. And the Fed is likely to hold the key again in 2007.
If you buy the consensus view on Wall Street, the U.S. economy will slow enough this year to spur the central bank to begin cutting short-term interest rates for the first time since 2003.
That’s the forecast of Pacific Investment Management Co., the Newport Beach-based bond-fund giant known as Pimco. There is an “overwhelming likelihood” of Fed rate cuts by June to keep the economy from faltering, said William Powers, a managing director at Pimco.
Powers says he’s sticking with that view despite some upbeat economic reports in recent weeks, including faster-than-expected U.S. job growth.
In theory, if the Fed begins to reduce short-term rates, long-term rates could drop as well, which would be good for investors who have locked in fixed yields on long-term bonds.
When market interest rates drop, older bonds issued at higher yields are worth more. That can add a capital gain onto a bond fund’s interest earnings. Interest plus or minus principal change equals the total return for a bond investment.
This is where things get complicated in the 2007 outlook. Long-term bond yields already have fallen significantly since June, with the Fed holding steady since raising its benchmark short-term rate from 5% to 5.25% on June 30.
The annualized yield on the 10-year Treasury note, a bellwether for other long-term rates, has fallen from a peak of 5.25% in late June to 4.65% on Friday.
Normally, long-term interest rates are higher than short-term rates. But for much of the last year the opposite has been true in the Treasury bond market: Short-term rates have been above long-term rates.
Because Wall Street usually anticipates Fed shifts, many analysts believe that the drop in long-term rates signals that the central bank will be cutting short rates this year.
But even if the Fed lowers its rate to, say, 4.75% by midsummer, that still would be above current long-term Treasury bond yields. So how much more could long-term rates drop?
Dan Dektar, chief investment officer at Smith Breeden Associates in Chapel Hill, N.C., figures the bond market already has priced in a Fed rate cut of nearly half of a percentage point. That means the potential for a capital gain in long-term bonds this year is limited, he says.
Also complicating the situation for U.S. bonds is that economic growth remains healthy in many other countries, which could keep rates elevated overseas and limit how far U.S. bond yields could decline.
If that’s the case, investors have to ask themselves whether it’s worth owning domestic long-term bond funds that pay 4% to 5% interest when they can earn the same in a money market fund with no risk of principal loss.
Yield-hungry investors have other options. For Californians, tax-free municipal bonds remain attractive, many financial advisors say. The yield on 10-year California general obligation bonds is just under 4%. For someone in the 32% combined federal and state tax bracket, that’s the same as earning 5.9% on a taxable bond.
What about the higher-risk, higher-yielding stuff, such as corporate junk bonds and emerging-market bonds?
Many bond market pros say they aren’t worth the risk with yields at current levels. The argument is that you aren’t being paid enough to compensate for the potential principal losses if the economy weakens more than expected and an increasing number of those bond issuers start having trouble paying their bills.
“This is not the time to be introducing junk bonds to a portfolio for the first time,” said Jeffrey Gundlach, chief investment officer at money manager TCW Group Inc. in Los Angeles.
Instead, he said, “the average investor should be consciously moving to higher-quality assets.” One of his favorite sectors: mortgage-backed bonds that carry top credit ratings.
Even if their returns are meager, high-quality bonds -- U.S. government issues or corporate bonds rated investment grade -- would provide a portfolio buffer if the economy were to take a sharp turn for the worse, slamming stocks.
If the economy fell into recession, high-quality bonds might be the best-performing asset in a diversified portfolio, because many investors would run for safety.
The one scenario that few Wall Street pros foresee is a stronger, rather than weaker, U.S. economy in 2007, with a surge in inflation. That could force the Fed to raise short-term rates further.
If that’s your bet, and you turn out to be right, all bonds could be in for a rough time, and the only smart place to be in the near term probably would be money market funds.
