As growth outlook improves, some investors swap bonds for stocks

Market Beat

Millions of Americans have turned their backs on the stock market since the 2008 crash.

But lately, some of them must be wistfully looking over their shoulders.

The Vanguard 500 Index fund, which tracks the blue-chip Standard & Poor’s 500 index and is a staple mutual fund of 401(k) retirement plans, now is up 13.3% year to date, counting price appreciation and dividend income.


Buy-and-hold bombed as a stock investment strategy from 2000 through 2008, but if this year’s gains stick the market will have generated back-to-back double-digit returns in 2009 and 2010.

Who knew?

For the last three months, stocks have been getting the benefit of the doubt from investors who are taking a much more upbeat view of the economy’s prospects in 2011.

And that same mood shift is ruining the party in what had been many investors’ favorite hideout since 2008: the bond market. Longer-term interest rates have jumped over the last two months, devaluing bond portfolios and leaving a trail of red ink in most fixed-income sectors.

That reversal of fortune may be particularly jarring because it was so easy for bond investors to be lulled into complacency over the last two years.

In the aftermath of the crash, Treasury, corporate and municipal bonds promised regular interest earnings and far less price volatility than stocks. What’s more, as interest rates in many sectors of the bond market fell for much of 2009 and 2010, that decline boosted the value of older bonds.

The Pimco Total Return bond fund, the world’s largest, gained 13.4% in 2009 and was up 11% in the first 10 months of this year, including price appreciation and interest earnings.

But since late October the bond market’s reputation as a refuge has been battered. As longer-term interest rates have risen investors in most types of bonds lost money last month, at least on paper, and are in the red this month as well.

The losses generally aren’t heart-stopping. The Vanguard Total Bond Market index exchange-traded fund, which owns a broad mix of government, corporate and mortgage bonds, is down about 3% from its record share price reached Nov. 4. The Pimco fund is off 3.7%.

Funds that own longer-term bonds, particularly tax-free municipal issues, have lost more. The average muni bond fund is down 4% since Sept. 30 but up 2.2% for the year, according to Reuters/Lipper.

Still, the mood change in the bond market has been palpable. Many investors are rethinking that most basic asset-allocation decision: how to split money between stocks and bonds.

“You’re starting to see a whole different landscape in the fixed-income market,” said Tom Tucci, head of Treasury trading at RBC Capital Markets in New York. “There’s a reallocation of capital away from fixed income” and into other assets, including stocks, he said.

Remember: It’s the big-money players who matter. If they keep selling bonds, they can steamroll the market.

This week, yields on Treasury securities rose across the board to the highest levels since at least early summer. The 10-year T-note ended Friday at 3.29%, up from 3% a week earlier.

Bonds’ pain was stocks’ gain. The S&P 500 index rose 0.6% to 1,240.40 on Friday, its highest level since September 2008. The technology-dominated Nasdaq composite index reached a nearly three-year high.

Investors are demanding higher rates on bonds — and are willing to pay higher prices for stocks — for the same reason: They’re betting that the economy will accelerate next year.

The Federal Reserve is trying to spur growth with its massive new program to buy Treasury bonds, launched Nov. 4. The Fed’s goals are to try to keep longer-term interest rates suppressed and to funnel more cash into the real economy.

But the Fed had to know that if investors began to believe that it would succeed in boosting the growth outlook, interest rates might rise despite its bond purchases. Plus, bond yields had tumbled in September and October in anticipation of the Fed’s move, so some snap-back shouldn’t have come as a surprise.

More important for the economy was President Obama’s deal this week with Republican leaders that would extend the 2001 and 2003 income tax cuts and line up other stimulus measures, including a cut in the payroll tax.

With that deal in hand, many economists rushed to raise their U.S. growth estimates for 2011 by as much as one full percentage point. With growth typically in the low single digits, an extra point is a big deal.

Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, N.Y., now expects 3% growth next year and says the rate “could easily be higher, depending on just how much of the stimulus cash is spent rather than saved or used to repay debt.”

With the Fed’s bond-buying and the tax deal “we get a much-needed one-two punch for an economy that was looking pretty weak,” said Diane Swonk, chief economist at Mesirow Financial Holdings in Chicago.

But that isn’t what an investor with a portfolio dominated by bonds wants to hear. Slow growth suits much of the bond market just fine because it fosters lower interest rates and keeps inflation down. For the Treasury market, not only is faster growth a threat but the tax deal also all but guarantees a wider budget deficit and therefore more bonds coming to market.

Even so, bond investors need to keep perspective. First, the economic optimists could be wrong. If the recovery fades, money could panic back into bonds.

Also, if you own bonds to get regular income, you’re still getting it. And if you wanted an asset that wasn’t likely to lose as much as stocks could lose in any given period, bonds still fill that bill.

Given the jump in yields in the tax-free muni market, in particular, it’s a good time for income-hungry investors to be looking at high-quality munis, says Matt Fabian, an analyst at research firm Municipal Market Advisors in Westport, Conn.

Yet investors also should be realistic about what bonds can do for their portfolio from this point. Unless market interest rates fall sharply again, bonds aren’t going to provide much if any capital appreciation. That will leave you with your interest return, which probably is in the mid- to low-single digits.

And if rates keep rising, bond principal losses could more than offset expected interest earnings over the next year or more.

If you need growth for some portion of your portfolio, you’ll have to turn somewhere else.

Stocks provide no guarantees, of course, and it’s understandable that many Americans developed a deep distrust of the equity market after 2008.

But if the economic picture in fact brightens in 2011, stocks will offer what bonds can’t: a chance to benefit from earnings and dividend growth.

If you’re entirely out of the market, the great danger is that you’ll finally want to get back in at exactly the wrong time — when you just can’t stand it anymore because share prices are up far more than you thought was possible.