For bond investors, a good time for a reality check
The stock market got some revenge in the third quarter — but the bond market still got the money.
Share prices rebounded sharply from their spring losses as fear of another recession eased and the Federal Reserve pledged to pump more cash into the economy if needed to bolster growth.
The average domestic stock fund surged 10.5% in the three months ended Sept. 30, according to Morningstar Inc. Foreign stock funds posted even bigger gains.
But many investors haven’t been riding the equity market’s latest wave. U.S. stock funds have been suffering net redemptions for most of the last year, and the outflow of money from the funds accelerated in the latest quarter.
Investors pulled a net $39.2 billion from domestic equity funds in the last three months, or about 1.1% of total assets, up from a $21.5-billion outflow in the second quarter, industry data show.
By contrast, an avalanche of money continues to pour into bond funds, the public’s clear favorite investment since early 2009. Bond funds had net inflows of $86.4 billion last quarter, up from $63.5 billion in the spring period.
Bond fund returns mostly lagged stock fund returns in the third quarter, but bond investors can’t complain: Most fixed-income funds were up between 3% and 6.5% in the period, counting interest earnings and capital appreciation, as another steep drop in market interest rates made existing bonds more valuable.
What’s more, in the first nine months of this year the average bond fund beat the average equity fund, although a rally in stocks last week narrowed the performance gap.
But the better things get for bonds, the louder are the warnings that investors may have been lulled into a false sense of security — a feeling that they can’t lose money in fixed-income investments, or that bonds’ returns over the last two years can go on indefinitely.
The continuing slide in interest rates, as the U.S. economy has struggled and the Fed has kept its benchmark short-term rate near zero, has left many Americans starved for investment income from traditional low-risk sources, such as bank savings certificates and money market mutual funds.
That has made the low- to mid-single-digit yields on bonds more alluring.
With short-term interest rates so paltry in much of the developed world, the hunt for income has become a global affair. That has played to the advantage of many companies and countries looking to borrow at relatively cheap rates via bonds.
Just last week the Mexican government issued $1billion of bonds at an annual interest rate of 6.1%. The most striking thing about the sale: Mexico locked in that rate for 100 years. The bonds mature in 2110.
“The danger is that people are so desperate for income, they’re taking on more risk than they understand,” said Miriam Sjoblom, who tracks bond funds for Morningstar in Chicago.
Bond investors have heard that before. But the lower interest rates get, the more the math undeniably works against bond owners.
Consider: The Pimco Total Return bond fund, the world’s biggest, gained 9.5% in the first nine months of the year. But 7.4 percentage points of that return was from appreciation of the fund’s share price as its bonds rose in value because market interest rates fell. Interest earnings on the fund’s bonds accounted for the other 2.1 percentage points.
To put it another way, if market rates had held steady in the period, the Pimco fund might have earned only that 2.1%, depending on how fund chief Bill Gross managed the portfolio.
And if market interest rates had jumped instead of falling, devaluing the fund’s bonds, the drop in the fund’s share price might have more than offset the interest earnings, at least on paper.
With average annual interest yields under 5% on many funds that own high-quality bonds, it wouldn’t take much of a backup in market rates to wipe out most of that interest return.
“There’s not a whole lot of yield left out there,” said Jeff Tjornehoj, senior research analyst at fund tracker Lipper in Denver.
Yet bond market bulls note that the Federal Reserve may soon try to drive longer-term interest rates even lower: Fed policymakers have signaled they’re considering a major new program of buying Treasury bonds, hoping to put downward pressure on interest rates across the board to help bolster the economy.
Rather than try to predict Fed policy and its success or failure, most bond fund investors probably would do better to make sure they have a basic understanding of what they own and the potential rewards compared with the risks.
Start with this checklist:
• Try to assess how much principal risk you’re taking. If you own a bond fund, the one number you need to know is the fund’s “duration,” which measures the portfolio’s sensitivity to market interest-rate swings.
Duration is related to the average maturity of a fund’s holdings (i.e., how long before the bonds mature and repay investors’ principal, on average), but it’s a more accurate yardstick. And it should be easy to check on your fund’s website.
The $80-billion Vanguard Total Bond Market Index fund, which owns a diversified mix of high-quality bonds, has a duration of 4.3 years. That means that if market interest rates overall rose one percentage point, the fund’s portfolio, and share price, would be expected to drop 4.3% in value.
A fund with a duration of 2.2 years, by contrast, would lose 2.2% of its principal value if market rates rose one percentage point.
So funds with longer durations face greater risk of loss if rates jump. Duration also works the other way, telling you how much a portfolio should rise if market rates fall.
• Get a handle on what kind of bonds you own. Many diversified bond funds own a mix of government, corporate, mortgage-backed and other bonds. A fund also might own both high-quality and lower-quality (“junk”) bonds.
It’s worth taking the time to take a look at your fund’s mix, because different bond sectors could fare very differently depending on what happens in the economy.
Interest rates on U.S. Treasury bonds are at or near generational lows as many investors have sought relative safety. If the surprise is that the economy improves, and inflation rises, Treasury yields could surge.
But market rates on many lower-quality corporate and tax-free municipal bonds might stay fairly level or could even decline if the economy brightens, if investors view the bonds’ issuers as financially healthier.
Rick Keller, an Irvine financial advisor, said he has boosted some clients’ holdings of junk bonds and emerging-market bonds recently because he thinks their yields are appealing at current levels, while he thinks higher-quality bond yields are too low to make them worth the risk if market rates rise overall.
If the economy worsens, however, it’s conceivable that yields on Treasury bonds could continue to slide, particularly if the Fed is buying them aggressively.
The Wasatch-Hoisington U.S. Treasury fund is betting heavily on lower government-bond interest rates. The fund, which soared 24.4% over the last nine months, owns mostly long-term Treasuries and has a duration of about 19 years.
Lacy Hunt, a principal at the firm, thinks the economy is in danger of sliding into deflation, meaning a broad-based decline in prices and wages. In that environment, he said, Treasury yields would be likely to plunge as investors continue to rush for havens.
• Think about the main reason you own bonds. If you shifted money from stocks to bonds over the last two years to reduce the risk of losing a large chunk of your capital, your reasoning was logical — and still is.
Funds that own high-quality bonds are unlikely to suffer the kind of short-term losses that can hit stocks. A bond is a promise to make specified payments, and the vast majority of bond issuers will make good on their promises. That makes bonds inherently safer than stocks.
Still, if you have money you absolutely can’t afford to lose, it belongs in a bank account, not a bond fund.
During the financial-system meltdown of late 2008, even many high-quality bonds briefly sank in value as investors fled in panic. And lower-quality issues were hammered. The average junk bond fund plunged 18.5% in the fourth quarter of 2008, close to the 21.8% drop in the average U.S. stock fund.
In 2009 junk funds roared back, gaining 46.2% compared with a 29.9% gain for the average stock fund.
But if the main reason you own bond funds is for income, you may have to lower your sights. Unless market interest rates rise significantly, fund managers will be reinvesting the proceeds from older, maturing bonds in new bonds that pay less.
So “even if interest rates held steady from here, [income earnings] will continue to decline” for the foreseeable future, said Vanguard Total Bond Market portfolio manager Ken Volpert.
The only way a fund manager could boost income in that scenario would be by taking more risk.
• Check your fund’s expenses. With interest rates so low, bond fund management fees are a bigger factor than ever in determining your ultimate return. The more the manager takes, the lower your return.
Morningstar data show that the average annual expense ratio for government- and corporate-bond funds is about 1%. Muni bond funds tend to charge between 1% and 1.3%, junk-bonds about 1.2% and emerging-market funds 1.4%.
If your fund is charging more than average, you should be getting above-average performance. If you aren’t, consider shopping for a lower-cost alternative.
tom.petruno@latimes.com
