Why should anyone be investing in bonds at a time when rising interest rates could rob you of profits? Despite losses for the typical bond investor in 2018 (because higher interest rates push down the value of existing bonds), bond investing makes sense in 2019 for two important reasons…
• The worst of the interest rate increases should be over, so even though bonds won’t soar in price, investors likely will get better returns from bonds than from savings vehicles such as money-market accounts and certificates of deposit (CDs).
• At a time when the stock market has become very volatile, bond investments can help stabilize a portfolio.
But you have to be very careful to use the right kinds of bonds for this economic environment.
Here’s how fixed-income investors can navigate the bond market safely this year and how to find the best opportunities…
A BETTER YEAR FOR BONDS
US economic growth likely will decelerate this year, which may continue to roil the stock market but actually could reward patient bond investors. In 2018, economic growth jumped and the Federal Reserve, in an effort to head off potential inflation, raised short-term interest rates at a pace that investors worried would lead to an economic recession.
But I expect gains in gross domestic product (GDP) to moderate in 2019 as the sugar high from corporate tax cuts wears off. Likely political gridlock in a divided Congress assures that there will be no major fiscal-stimulus bills. That should keep inflation and wage growth relatively mild. The Fed likely will raise short-term interest rates no higher than a range of 2.75% to 3%, compared with 2.25% to 2.5% at the end of 2018.
In November, Federal Reserve chairman Jerome Powell described rates then as “just below” neutral, which means the level at which rates neither slow nor boost a healthy US economy. That’s an early signal that the Federal Reserve’s cycle of raising rates, which started about three years ago, could be drawing to a close. I expect the benchmark 10-year Treasury to yield in a range from 3% to 3.5% during 2019.
BOND FUNDS TO FAVOR
The following four bond funds are among the ones most likely to benefit from a less threatening environment for bonds this year…
Fidelity Floating Rate High Income (FFRHX) thrives in rising-rate environments. It invests in short-term, bondlike securities known as adjustable-rate loans made by banks to companies. The yields on these securities typically reset every 30 to 90 days, adjusting upward as interest rates rise. The loans typically are rated below investment grade, which means a greater-than-normal risk that the borrowers will default. However, the fund takes a conservative approach by making sure borrowers have solid balance sheets and enough cash flow to cover their interest payments. Recent yield: 5%. One-year performance: 0.1%. 10-year annualized returns: 3.9%.*
Osterweis Strategic Income (OSTIX). I am avoiding most high-yield (junk) bond funds this year because their yields aren’t high enough to compensate for the risk of heavy losses that would occur if the economy stalls. But this fund has a unique strategy. It focuses on short-term junk bonds and makes sure that each issuer’s near-term outlook is strong. The fund further mutes volatility by holding large amounts of cash until the fund manager finds attractive investments. Recent yield: 4.7%. One-year performance: –0.7%. 10-year annualized returns: 6.7%.
Loomis Sayles Bond (LSBRX) is a multisector fund that can invest almost anywhere in the fixed-income universe. It’s a bet on the talent of legendary manager Dan Fuss, who has run the fund for nearly three decades and successfully navigated many rising interest rate environments. The fund is best suited to aggressive fixed-income investors because Fuss takes a contrarian approach and isn’t afraid of short-term losses. Lately he has found the most value in high-yield bonds in the beaten-down energy sector. Recent yield: 4.3%. One-year performance: –3.1%. 10-year annualized returns: 7.8%.
Vanguard Intermediate-Term Tax-Exempt (VWITX). Despite the new federal tax law, which altered tax brackets and made municipal bond after-tax returns less advantageous relative to US Treasuries, municipal bonds still had positive returns in 2018. Reason: US Treasury yields still are so low that munis look attractive even with less of a tax break. That trend should continue and boost this Vanguard fund, which spreads its assets over nearly 8,000 bond holdings with high credit quality and a moderate duration—a measure of interest rate risk—of 5.5 years. Low fees give the fund an advantage over competitors. This Vanguard fund’s recent 2.5% yield is the equivalent of a 4% yield in the highest tax bracket. One-year performance: 1.3%. 10-year annualized returns: 4.1%.
BOND TYPES TO AVOID
Even if 2019 turns out to be a better year for fixed-income investments, and interest rates don’t rise much, the following types of bonds offer little to no upside for the risks that you would be taking on…
Long-term government and long-term corporate bond funds hold very high-quality bonds, typically ranging in maturity from 10 years to 30-plus years. But that doesn’t make them safe. In 2018, long-term government bonds had an average total return of –0.7% and long-term corporate bonds returned –5.5%. Even a small rise in rates is likely to produce negative returns again for long-term bonds in 2019. The yield was recently 3.1%, on average, for long-term government bonds and 4.8% for long-term corporate bonds—relatively paltry amounts for which to expose yourself to such risk.
Short-term corporate bonds. In 2018, the total return was 1.3% for short-term government bonds and 1.5% for short-term corporate bonds. Very conservative investors are better off getting a risk-free yield from a one-year CD (recently as high as 2.9%) or from an FDIC-insured money-market account (recently 2.3%) that will benefit if interest rates rise further.
Emerging-market bonds. This was the best area of the global bond market two years ago, in 2017. But a strengthening US dollar hurt the value of these bonds, which typically are denominated in dollars. They were down 6% in 2018. I believe that the dollar will remain strong, which means that despite recent yields of about 6%, these bonds and the funds that invest in them are just too risky in 2019.
*All one-year and 10-year annualized returns are from Morningstar Inc. and calculated through December 31, 2018, unless otherwise noted.