The nearly nine-year-old bull market in stocks has been impressive. But there’s another bull market that has lasted four times as long. The big question is, can that bull market in bonds—which saw interest rates peak in October 1981 and generally drift downward since then—survive to its 37th birthday and beyond? Or will interest rates rise sharply enough that bond losses mount—and bond investors lose a lot of money?
Fixed-income expert Robert M. Brinker says bonds and bond funds still can play an important role in your investment portfolio without subjecting you to big losses—that is, if you know how to navigate the increasingly dangerous bond and bond-fund landscape.
Here’s what Brinker told Bottom Line Personal that our readers need to watch out for this year…which areas of the bond market look most attractive…and which to avoid…
Bonds did OK in 2017 because the economic environment was relatively benign. Interest rates inched higher gradually…inflation was subdued…and the economy gained speed without overheating. But 2018 poses greater risks. They include…
Higher interest rates. I expect the Federal Reserve to continue gradually increasing its benchmark short-term interest rate, likely raising it three times in 2018 to a range of 2% to 2.25% by the end of the year, up from 1.25% to 1.5% in December. However, in late 2017 the prospect of Congress cutting taxes to stimulate the economy was increasing the possibility that the Fed might accelerate interest rate hikes.
Unwinding of the Federal Reserve balance sheet. Over the past decade, the Federal Reserve bought $4.2 trillion worth of long-term US Treasury bonds and other US government securities to boost the economy. Now it has started selling off these assets at a pace that will reach $50 billion a month in 2018—which could push down the prices of long-term Treasuries and dramatically push up their yields.
My forecast: The yields on 10-year US Treasuries, recently 2.38%, could rise to nearly 3% by the end of 2018. But there is a danger that the yields could go much higher—and, therefore, the prices much lower.
If you plan to own individual bonds and hold them to maturity, then fluctuating bond prices don’t affect you directly. But if you plan to sell your bonds before maturity, or if you own shares in bond funds that have no set maturity dates, you could suffer substantial losses and so you should consider trimming or eliminating your positions.
The following types of bond funds face significant dangers…
Long-term government bond funds. This type of investment-grade fund had total returns—which include the dividends paid plus any capital appreciation—averaging 8.8% in 2017 through December 8.* But the recent average yield was unappealing, only about 2.6%, and the average “duration” was 18 years. (Duration is a measure of how much value a portfolio of bonds stands to lose as interest rates rise.) That translates into an 18% loss for every one-percentage-point rise in interest rates.
Short-term government and short-term corporate bond funds. This category had total returns averaging 1.3% in 2017 and a recent yield of 2%. If your goal is safe, predictable income, you can find FDIC-insured deposit accounts with similar yields and no risk of losing principal at online banks and credit unions.
High-yield bond funds. The total return on high-yield, or “junk,” bond funds was 6.1% in 2017, and the average recent yield was 5.3%. That is not adequate compensation for the risks if there is an economic slowdown or a stock market pullback. In these environments, junk bonds can suffer losses almost as severe as those of stocks.
Emerging-market bond funds. This was the leading area of the bond market in 2017, with total returns of 9.4%. But those gains were largely fueled by a weakening dollar. As the Fed raises interest rates, I expect a modest appreciation of the US dollar, making these funds too risky for the yields they recently offered in the 4.4% range.
The following types of bond funds, including my favorite pick in each category, have promising outlooks for this year…
Intermediate-term bond funds. Some intermediate-term bond funds offer decent yields of 3% or higher, and the bonds they hold tend to have durations of five years or less.
My favorite now: DoubleLine Total Return Bond Fund (DLTNX), run by Jeffrey Gundlach, one of the top managers in the bond world. It has consistently delivered solid returns. The fund has a duration of just 3.8 years. Gundlach invests primarily in mortgage-backed securities, which are bonds composed of bundles of residential mortgage loans that can do well in rising-rate environments. Recent yield: 3.2%. Annualized performance since its 2010 inception through November 30: 6.4%.
Floating-rate bond funds. Floating-rate funds (also called bank-loan funds) buy bondlike securities known as bank loans. These loans, made by major banks to corporations, don’t have fixed payout rates as most bonds do. Instead, their payouts typically reset every 30 to 90 days, adjusting upward as interest rates rise (or downward as rates fall).
My favorite now: Fidelity Floating Rate High Income Fund (FFRHX) takes a conservative approach, investing in loans made to companies that generate lots of cash flow so they can cover interest payments. Recent yield: 3.5%. 10-year annualized performance: 4%.
Multisector bond funds. These funds can do well because they allow savvy bond managers to invest anywhere they see relative value and safety in the fixed-income universe.
My favorite now: Pimco Income Bond (PONRX) holds more than 5,500 bonds and recently had a duration of 2.1 years through its mix of bank loans, mortgage-related securities and emerging-market debt. Its performance ranks in the top 5% of its category over the past decade. Recent yield: 3.3%. 10-year annualized performance: 8.6%.
Conservative-allocation funds. These are bond funds that typically put part of their portfolios in dividend-paying stocks. They look compelling in the coming year because stocks should do well, boosting the funds’ returns. (Of course, if stock prices fall, so will the value of the funds’ stock
holdings.)
My favorite now: Vanguard Wellesley Income Fund (VWINX) keeps about 60% of its assets in intermediate-term corporate bonds and Treasuries and the rest in large-company dividend-paying stocks. The fund’s performance ranks in the top 4% of its category over the past decade. Recent yield: 2.6%. 10-year annualized performance: 7%.
