Bonds prices weren’t supposed to soar in 2019. And yet, as the Federal Reserve pushed down interest rates to avoid a recession…and rampant inflation was nowhere in sight…bonds delivered their best performance in nearly two decades, gaining 8.7% overall based on the Bloomberg Barclays US ­Aggregate Bond Index. With interest rates so low now, can the bond rally continue through 2020? It will be a challenge to get positive returns, but here’s how to position your bond investments for the best chance at ­further gains…

Expect a Baby Bear Market in Bonds

Many of the catalysts that pushed down yields to near-record lows in 2019—and sent bond prices rocketing higher—have diminished. Long-term interest rates are more likely to rise than drop further. That means many bond investments likely will have flat returns this year, outside of the interest income they provide. And bonds with longer maturities likely will face losses because they suffer the most when rates rise.

Specifically, this is the likely scenario affecting bonds in 2020…

The Fed keeps to the sidelines. I don’t see the Federal Reserve taking any ­action in 2020 because inflation is likely to remain under its target of 2%. I expect the Fed to maintain its benchmark interest rate at the same range it was in December 2019—1.5% to 1.75%. 

Fears of an imminent recession ­recede. I expect the US gross domestic product (GDP) to grow 2% in 2020. That’s hardly robust, but enough to lower ­recession fears, especially with the lowest unemployment in five decades. Modest economic growth means investors aren’t going to rush into bonds as a safe haven the way they did last year, pushing down their interest rates and pumping up their value. For instance, to attract investors, the yield on 10-year US Treasury bonds, recently around 1.9%, is likely to rise to 2.25% by the end of 2020.

US–China trade tensions likely won’t worsen. Last year, bond prices benefited as investors feared an all-out trade war that could cripple the global economy. Although the trade standoff could drag on this year, a major escalation is unlikely. And any further progress in trade talks could improve the business outlook in the US and abroad. That would hurt the value of bonds as emboldened investors dump them to get back into stocks.

Bond Types to Avoid

If you hold individual bonds to maturity, fluctuations in interest rates won’t affect you. But if you invest in bond funds, the following categories have very limited upside in 2020. 

Short-term government and short-term corporate bond funds. Although funds focused on bonds with ­maturities of less than five years suffer minimal losses when interest rates rise, recent yields averaged just 1.8%, making them unattractive. You can find better yields with FDIC-insured savings and money-market accounts—up to 2.2%—at online banks and credit unions without any risk for loss.

Long-term government bond funds. These funds, which typically hold bonds with maturities ranging from 10 years to 30 years, returned an average of 15% in 2019, topping all other bond categories. But they are at the highest risk for losses this year if long-term interest rates rise, because they have an average duration of 18. Duration is a measure of how much value a portfolio of bonds stands to lose as interest rates rise. For every percentage point rise in long-term interest rates, these funds could suffer an 18% loss.
Average recent yield: 2.2%.

High-yield or “junk” bond funds. Because junk bonds are susceptible to default and can be as volatile as individual stocks, they typically must offer high yields—6% or more—to be attractive. After overall returns of 15% in 2019, the average yield on junk bonds ended the year at about 5%. That’s not enough to compensate for their risks. Many companies with subpar credit ratings have such high levels of corporate debt that default rates could soar if the economy stumbles. 

Bond Funds to Favor

The following bond funds are my favorites because they have the most promising outlooks this year… 

Dodge & Cox Income (DODIX). Intermediate-term bond funds such as this one, which focus on investment-grade bonds that can do well even in flat or down bond markets, are in a relative sweet spot for 2020. A team of nine comanagers looks for undervalued corporate bonds without taking on too much interest rate or credit-quality risk. The portfolio recently had an average credit quality of A and a duration of just four years. The result is a portfolio with better yields than US Treasuries that can provide a counterweight to volatile stocks. Recent yield: 3.1%. 2019 performance: 9.8%. 10-year annualized performance: 4.4%.* 

DoubleLine Total Return Bond (DLTNX) focuses on mortgage-backed securities, composed of home mortgages that are packaged together into “pools.” These securities offer higher yields than Treasuries and are mostly guaranteed against default by US government agencies. Fund manager ­Jeffrey Gundlach has been able to boost the fund’s total returns by keeping about one-third of its portfolio in securities composed of riskier mortgage loans that are not guaranteed by federal agencies. Even if the economy slows, the housing market will remain relatively strong and these mortgage bonds should not pose much default risk. Recent yield: 3.2%. 2019 performance: 5.5%. Five-year annualized performance: 2.9%.

Loomis Sayles Bond (LSBRX) can choose almost any types of fixed-­income investments around the world. It has done well in many types of economic and bond environments because manager Dan Fuss, who once managed Yale University’s endowment portfolio, excels in finding value in overlooked areas of the bond market. He recently positioned the fund in intermediate-term corporate bonds, Canadian dollars and a handful of dividend-paying stocks such as AT&T and Ford Motor Co. Recent yield: 3.1%. 2019 performance: 11.4%. 10-year annualized performance: 5.7%. 

Vanguard Wellesley Income (VWINX) is a hybrid fund that keeps about 65% of its portfolio in fixed-income investments and about 35% in undervalued, blue-chip, dividend-paying stocks. Hybrids are my favorite category for 2020. Reasons: Stocks are likely to outperform bonds and boost total returns, while bonds offer a measure of safety. That said, this fund is for aggressive investors because it will be far more volatile than an all-bond portfolio in stock market downturns. Recently, the bond portion of the fund held mostly intermediate-term, investment-grade bonds. The stock portion consisted of companies such as Comcast, Pfizer and Verizon Communications. Recent yield: 2.6%. 2019 performance: 16.4%. 10-year annualized performance: 8%. 

*Performance figures are through December 31, 2019, and provided by Morningstar Direct.