Can bonds continue to perform well after two years of strong gains and amid a struggling, ­pandemic-weary economy? An index of the overall US investment-grade bond market gained 7.2% in 2020 as of December 11* and 8.7% in 2019. That’s due in great part to sinking interest rates, which took a further dive as the Federal Reserve fought to combat the pandemic-induced recession and pledged to keep short-term rates near zero for years. But record-low interest rates leave little room for further gains in the bond market, whose prices move in the opposite direction to interest rates, and make it harder to use bonds to offset stock volatility in your ­portfolio. Bottom Line Personal asked strategist Robert M. Brinker which bond funds to avoid and which to favor in this tricky environment…

The Outlook

In 2021, for the overall bond market I expect flat or slightly negative total returns, which reflect both the yield and changes in price. That means you should steer clear of certain types of bond funds that are most likely to do poorly in 2021. However, there are pockets of opportunity for yield and/or capital appreciation in areas that include mortgage-backed securities, intermediate-term corporate bonds and junk bonds with short maturities. 

Major factors that will affect bonds in 2021…

Short-term interest rates are likely to remain unchanged, in the 0% to 0.25% range. 

Long-term interest rates could rise if the economy continues to improve and commodity prices rise, triggering higher inflation. The yield on 10-year US Treasuries, recently at 0.9%, should climb modestly into the 1% to 1.5% range by year-end 2021.  

The US economy is likely to grow 3% in 2021 as new vaccines and treatments help harness the pandemic and the federal government provides additional stimulus.

Inflation, as measured by the Consumer Price Index, could tick up to the 1.5% to 2% range for 2021, from a recent 1.2%, driven by stronger consumer spending. 

Bond Funds To Shun

If you hold individual bonds to maturity, fluctuations in interest rates and bond prices won’t affect you directly. But if you invest in bond funds, the following categories are unattractive. Consider trimming or selling existing holdings, and avoid new purchases…

Short-term government and short-term corporate bonds. This category, which focuses on bonds with maturities of five years or less, had total returns of 4.6% in 2020 and a recent average yield of 0.35%. If you want reliable income with no risk of losing principal, you can find yields more than double that in FDIC-insured online savings and money-market accounts.

Long-term government bonds. This type of fund, which typically holds bonds with maturities ranging from 10 to 30 years, benefited greatly as nervous global investors flocked to the security of US Treasuries. This bond category outperformed every other bond category over the past two years. But its average yield dropped to just 1.4%. Also, for the benchmark index of long-term government bonds, the average “duration”—a measure of how sensitive a bond or portfolio of bonds is to changes in interest rates—is 18.5 years. That duration indicates that if long-term rates rise just one-half percentage point, the funds would suffer a 9.25% drop in price.

Municipal bonds. These bonds, which pay interest that is exempt from federal tax and sometimes state and local taxes, are popular with high-income individuals because they provide higher after-tax yields than comparable US Treasuries. But the economic fallout from the pandemic has wreaked havoc on many state and local government balance sheets, making muni bonds unusually volatile. Note: The average yield on ­intermediate-term munis was recently 1% (the equivalent of a 1.3% after-tax yield on Treasuries in the 24% tax bracket). If you want to own munis, favor “general-­obligation” bonds from fiscally strong states such as Texas and Virginia, not munis focused on such things as airports or transportation projects that can’t raise taxes to boost revenue. 

Foreign government bonds are often attractive to more aggressive fixed-income investors because they typically offer higher yields but also greater risk than US Treasuries. But 10-year government bonds in Japan had a recent yield of just 0.014%. And 10-year bonds in France, Switzerland and Germany all paid negative yields recently, meaning that you could lose money if you hold the bonds to maturity. Bonds issued by countries with developing economies yielded a recent average of 3.6%, which is not enough to compensate for the considerable volatility they entail. 

Bond Funds to Favor

While avoiding the bond funds described above in 2021, consider investing in the following funds, which are less vulnerable to rising interest rates…have greater potential for capital appreciation…or pay relatively high yields.

Dodge & Cox Income (DODIX).
Many investors invest in ­intermediate-term, investment-grade corporate bond funds with maturities between five and 10 years as core portfolio holdings. Reason: They often provide the best trade-off among yield, interest rate risk and total return. This bond category returned 6.9% in 2020 and can do well in 2021 even if interest rates rise a bit. The Dodge & Cox fund uses a simple but effective strategy that’s attractive for fixed-income investors who can stand moderate risks. Specifically, it holds more than 1,100 bonds considered undervalued, with an average credit rating of A and a duration of five years. Recent yield: 2.5%. 10-year performance: 4.7%. 

Vanguard Wellesley Income (VWINX). With interest rates on high-quality bonds so low, more aggressive investors may want to take a calculated risk by adding exposure to dividend-paying stocks. This venerable hybrid fund has maintained the same strategy for the past 50 years. It keeps about 40% of its portfolio in blue-chip stocks that seem undervalued and pay a dividend…and the rest in intermediate-term corporate bonds. With the economy likely to grow 3% in 2021, the fund’s stock holdings should do well and push up its total return. Recent yield: 2.7%. 10-year performance: 7.8%.

Osterweis Strategic Income ­(OSTIX). High-yield (junk) bonds returned just 3.7% in 2020. I am mostly avoiding them because their yields in the 4% to 5% range may seem attractive but aren’t nearly high enough to justify the risk for heavy losses that would occur if the economy stalls…if issuers default on interest payments…and/or if the stock market sinks, since junk bonds correlate closely with stocks. However, the ­Osterweis fund offers a unique and cautious strategy that tends to excel in volatile markets. It holds about 135 bonds, with an average duration of just 1.8 years. So even if interest rates jump in 2021, the fund is unlikely to be hurt much. Also, manager Carl Kaufman excels at evaluating credit risk. Since the fund’s 2002 launch, none of its bond holdings has experienced a default. Recent yield: 4.15%. 10-year performance: 4.9%. 

Vanguard GNMA (VFIIX) invests in more than 15,000 government-­guaranteed mortgage-backed securities (GNMAs), which are large groups of high-quality residential home mortgages that are bundled together and sold as investments. Its holdings are rated AAA and backed by the federal government against default, but they offer higher yields than comparable intermediate-term US Treasuries. That’s because the major uncertainty with GNMAs, which returned 3% in 2020, is that fast-rising interest rates would lower the value of the securities it owns. That’s unlikely to happen in 2021. Recent yield: 1.9%. 10-year performance: 3%.