Bonds: A refuge from May’s market mayhem
As many Americans shunned the stock market in favor of buying bonds in record amounts over the last year, financial writers including yours truly felt compelled to warn that bonds, too, carry risks.
But after the nightmare that stock investors just suffered through this month, most newbie bond owners probably figure they made exactly the right choice with their money.
Fixed-income securities aren’t risk-free, but in this month’s market mayhem they lived up to their billing as a haven compared with stocks.
And Wall Street, once again, had the feel of a casino whose odds are stacked against the small player.
Let’s look at May’s investment results the way a typical 401(k) retirement-account investor might:
?• Vanguard 500 Index fund, which tracks the Standard & Poor’s 500 stock index: down nearly 8%.
?• American EuroPacific Growth fund, one of the most popular foreign-stock funds: down 10%.
?• Pimco Total Return bond fund, the world’s biggest bond fund: down 0.1%.
Year to date, the Vanguard 500 fund is down 1.5%; the Pimco Total Return fund is up 3.8%.
There is a certain irony here. As most investors know, one of the triggers for the stock market’s sell-off was the debt crisis racking Europe’s weakest economies. Fear that Greece might default on its bonds spread this month to infect Spain, Portugal and Italy as well.
Global stock markets dived on worries that Europe’s woes could lead to another worldwide credit crunch that would zap the economy.
But even though this crisis is centered in European bonds, it hasn’t fueled a massive exodus from most other kinds of debt securities. Investors are being much more discriminating than they were after the catastrophic failure of brokerage Lehman Bros. in September 2008, when bonds and stocks were dumped across the board.
First, a refresher on how bond prices and yields work: When the market price of a bond drops, its interest yield goes up for new buyers. When a bond rises in value — because investors are buying aggressively —yields go down for new investors. Of course, once you own a fixed-rate bond, your interest rate stays the same for the life of the security.
This month, as in fall 2008, U.S. Treasury bonds were beneficiaries of markets’ ramped-up fear levels. As cash has poured into Treasuries, the annualized yield on 10-year T-notes for new buyers has tumbled to 3.30%, from 3.83% in mid-April.
Yields also have edged lower on many tax-free municipal bonds since April as money has continued to move into the securities. The average yield on 10-year California general obligation bonds was 4.28% on Friday, down from 4.57% in mid-April.
Matt Fabian, senior analyst at research firm Municipal Market Advisors in Westport, Conn., says the muni market has benefited from a continuing influx of “people who are buying to hold, not trading accounts.”
Those are exactly the type of investors the stock market has been lacking lately — which partly explains Wall Street’s insane volatility of the last four weeks. Short-term traders have been running amok.
Still, the bond market hasn’t entirely escaped collateral damage from Europe’s mess. Some corporate bonds, particularly below-investment-grade “junk” issues, have had a rougher road amid jitters over the economy. Investors have demanded higher yields to buy junk issues, pushing the bonds’ prices lower.
Even so, the sell-off in junk has been much less severe than what the sector suffered post-Lehman. The average junk-bond mutual fund had a negative total return of about 3.7% in May, according to data tracker Reuters Lipper. In October 2008, many junk funds’ losses topped 15% for the month.
Total return measures a fund’s interest earnings plus or minus the net change in the share price. Although prices of most junk bonds have dropped in May, that has been partially cushioned by the bonds’ interest payments, which now average about 9% annualized.
The main appeal of bonds, of course, is their regular interest earnings. That income also provides an offset against loss of principal if the security’s price drops.
High-quality bonds are supposed to be relatively conservative investments: You don’t expect to get rich off most fixed-income securities, and you surely won’t with interest rates at today’s relatively low levels. The goal should be to earn a decent rate of return compared with inflation and cash accounts while avoiding the kind of severe losses that the stock market can dish out.
And when the stock market roars — as it did in 2009, and might again after this pullback — bonds almost certainly will take a back seat. The average U.S. stock mutual fund rebounded 30% last year from 2008’s horrendous slump. The Pimco Total Return bond fund was up 13%, helped by falling market interest rates that made older, higher-yielding bonds rise in value.
Of course, bond investors still face risks. One is that Europe’s debt debacle could yet morph into a global credit crunch, fueling another near-universal rout in bonds.
Another is that the economy could sink back into recession, leading to rising defaults by bond issuers. That could spur investors to demand higher yields to buy bonds, depressing prices of outstanding securities.
Two other risks, meanwhile, have faded for the time being: the threat of rising inflation that would eat into bonds’ fixed-rate returns, and the potential for the Federal Reserve to begin raising short-term interest rates.
The core U.S. inflation rate was up 0.9% in April from a year earlier, the slowest pace of price increases since 1966. Inflation continues to be a no-show despite the economy’s recovery. That is sweet news for bond holders.
As for the Fed, policymakers might well prefer to start lifting interest rates, but Europe’s tumult will make it that much harder for the Fed to tighten credit any time soon. It would risk pushing Europe’s fragile financial system over the edge.
It’s an odd gift from the Europeans to U.S. bond investors: a debt crisis that has made owning debt more appealing.
