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Pop-quiz for bond investors: Was the May and June sell-off a speed-bump or a roadblock for the U.S. bond market?
The answer, of course, is no one knows for sure. But how you handle your bond investments now could be crucial to your returns for years to come.
The U.S. bond market lost 2.3% in the second quarter. And some analysts worry this could be the start of a long-anticipated period of rising rates and low returns across the fixed-income world — marking the end of a 31-year bull run in bonds.
"Investors need to think about bonds more strategically," says Jim Holtzman, an adviser with Legend Financial Advisors in Pittsburgh. "What's worked for the last 31 years — since interest rates peaked in 1982 — won't work for the next 10 years."
So what's the best move to make now? Here's some perspective on the market and tips on how to handle your bond investments going forward.
A. The answer is yes.
Bond prices and yields move in opposite directions, and the recent surge in yields has been painful. Yet since the Barclays Aggregate Bond Index — a broad measure of the U.S. investment-grade bond market — launched in 1986, it has had just two losing years: 1994 and 1999, when total returns fell 2.9% and 0.8%, according to Barclays.
Even in a rising-rate climate, investors may see nominal gains. From 1941 to 1981, interest rates rose from 2% to 16%, according to research from Fidelity Investments. Yet bonds never had negative returns over five- and 10-year rolling periods. And total returns averaged 3.3% a year over that span.
Adjusting for inflation, "real" bond returns averaged a negative 1.3% from 1941 to 1981, largely because of soaring inflation in the 1970s.
Today, though, the economy looks very different. Much of the inflation of the '70s was fueled by soaring oil prices. Back then, the economy was much more dependent on manufacturing and per capita energy consumption was higher than it is today. Gas prices, in fact, are lower today than they were in 1980, adjusted for inflation, according to the U.S. Department of Energy.
Further, the economy is now expanding well below its capacity, indicating inflation is likely to remain tame. The Consumer Price Index, the government's main inflation gauge, is rising at a 1.8% annual rate, well below the average 3.8% since 1946, according to the Federal Reserve Bank of Cleveland.
Another reason to own bonds: They can dampen stock volatility in a portfolio. In the past 15 years, the S&P 500 (.SPX) has fluctuated by an average 16% a year, according to Morningstar. Bonds fluctuated an average 3.6% — meaning bonds should be a stabilizing force in a balanced portfolio.
Bonds aren't just less volatile than stocks. They can help offset declines in stock prices. In 2008, the S&P 500 sank 37% while bonds stayed afloat, returning 5.2%. From 1926 to 2012, stocks fell in 24 years. Yet in 22 of those years, investment-grade bonds had positive nominal returns, according to Fidelity research.
The takeaway: Even if bonds hit some hurdles, they usually don't stay down for long and can help stabilize a portfolio, at least partially offsetting losses in stocks.
A. You probably shouldn't expect returns to be as high as they were in the last decade — an exceptionally strong period for bonds compared to stocks.
From 2001 to 2011, nominal bond returns averaged 5.8% a year, while stocks eked out a 1.4% average total return, according to data from Ibbotson Associates, a research and consulting firm in Chicago.
The next few years don't look nearly as promising for bonds. When the 10-year Treasury note yields less than 2.6% — about where the yield is today — bond returns have averaged less than 2% over the following 10 years, according to Fidelity research.
Those returns don't account for investment fees or taxes, which would erode your gains. And higher inflation rates would lower your real returns as well.
At recent prices, some research suggests stocks may be a better bet for long-term investors. Over a 20-year horizon, stocks are likely to return an average 7.6% a year, compared to 4.5% for bonds, according to a 2012 study by Ibbotson.
The takeaway: Bond returns could be relatively low going forward, compared to stocks.
A. For starters, make sure you have the right mix of bonds for your personal situation.
Investors in their 30s and 40s should hold 20% to 30% in bonds, says Trent Porter, a financial adviser with Priority Financial Planning in Denver.
Investors should gradually raise their bond exposure as they get older, depending on their income needs and other assets. Folks in their 50s and 60s should hold more in bonds — as much as 50% for someone age 65. But ultimately, how much to invest depends on personal factors, says Porter, and there's no blanket prescription that works perfectly for everyone.
As for the mix of your bond investments, most advisers recommend sticking with investment-grade bonds for 50% to 60% of your fixed-income bucket.
One option for such a core holding in the ETF space is the iShares Core Total U.S. Bond Market ETF (AGG), which tracks the investment-grade U.S. bond market. The fund has an expense ratio of 0.08%, among the lowest on the market, or just $8 for every $10,000 invested.
The fund offers "built-in diversification benefits," Morningstar analyst Timothy Strauts wrote in a recent report on the ETF, adding it's "broad enough to serve as the only fixed-income fund in many investors' portfolios." It currently yields 2.4%.
One drawback of the ETF is that it's somewhat sensitive to interest-rates. The ETF has a duration of five years, meaning the share price would fall roughly 5 percentage points for every one-point rise in rates.
For the rest of your bond holdings, advisers suggest investing in parts of the fixed-income market that aren't as sensitive to interest rates. Among them: junk bonds, non-government mortgage securities, floating-rate bank loans and foreign bonds.
Some advisers say these types of securities may fare better than traditional government and corporate investment-grade bonds going forward, especially if interest rates keep rising. Some non-traditional funds that Pittsburgh adviser Holtzman uses for his clients include DoubleLine Total Return Bond Fund (DLTNX), Osterweis Strategic Income Fund (OSTIX) and Templeton Global Bond Fund (TEGBX). Each of these funds has a lower duration than the AGG ETF, and the Osterweis and DoubleLine funds yield a bit more.
The downsides: These funds may take other risks to boost their yield, including credit risk and foreign market risk. Expense ratios are higher than the AGG ETF. And the Osterweis and Templeton funds each cost $75 to buy shares on the Fidelity platform.
For more non-traditional bond investing ideas, see 9 ways to boost the yield on your bond investments.
The takeaway: Investors should determine the right bond mix for their situation and consider investing strategically in non-traditional parts of the market.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.
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