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Q1 bond update: bonds shine

Despite the consensus, bonds performed well in Q1. Here’s what to keep an eye on.

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Looking back, I’m struck by the seemingly endless capacity of financial markets to confound the consensus. Despite the consensus that the great rotation out of bonds and into stocks had begun, the bond market performed very well in the first quarter, producing highly satisfactory returns across a range of market segments. U.S. investment-grade bonds, for example, generated a return of nearly 2%, and U.S. corporate high-yield bonds did even better, generating a return of nearly 3%. Municipal bonds were the strongest performers of all, checking in with a return of 3.3%, while global bonds—excluding the U.S. and emerging-market debt—produced a respectable 3% return.

Bonds shine

Investors came into the year convinced that the 30-year bull market in bonds was over. The perception that bonds were a bubble about to burst has been prevalent for some time. It took on new life last May, when the Federal Reserve announced that it would begin tapering its accommodative monetary policy, known as quantitative easing, in the second half of the year. Sure enough, the Fed began tapering in December, and investors interpreted this change in policy as a signal that a robust U.S. economic expansion was finally at hand. The economy, it was thought, would now begin growing on its own, without the need for extraordinary stimulus measures from Congress or the Federal Reserve. As a result, interest rates were likely to ratchet up to more normal levels, and as rates moved higher, bond returns were sure to disappoint. That thinking led bond investors to pull $105 billion out of taxable bond funds and $65 billion out of municipal bond funds in the second half of last year, following the Fed’s change in policy. The 30-year bull market in bonds, indeed, seemed to be over.

So, what happened? In the first week of January, investors were concerned by the news that China’s economy appeared to be slowing. This was followed up by a series of cautionary news items, including reports of capital flight in the emerging markets of Venezuela, Turkey, and Ukraine; lackluster U.S. macroeconomic data, especially in terms of job creation and consumer spending; and growing geopolitical concerns, capped off by Russia’s occupation and subsequent annexation of Crimea. Along the way, Janet Yellen was sworn in as the new head of the Federal Reserve, and she quickly affirmed that the Fed would continue to pursue the policies of her predecessor, Ben Bernanke, by maintaining low interest rates while scaling back on the Fed’s quantitative easing program. All these events were viewed favorably by the bond market, causing bond prices to be bid up, and bond yields to drift lower. It was only toward the end of March, when Janet Yellen announced that short-term interest rates might be raised as soon as the spring of 2015, that the bond market got spooked and sold off a bit, although much of that sell-off has already been recouped.

Not a normal recovery

This was not the first time that investors had been surprised by the resiliency of the bond market. Since June 2009, when the Great Recession of 2008 officially ended, investors have been waiting for a robust economic recovery to take hold, but so far to no avail. The robust economic recovery never seems to arrive, and this underscores an important lesson for all investors: This is not a normal economic recovery, for the simple reason that the recession that preceded it was not a normal economic recession. The Great Recession of 2008 was not induced in the usual way, by the Fed deliberately raising interest rates to cool off an overheated economy, but rather by a financial crisis precipitated by too much debt. Academic studies have shown that it takes eight years, on average, for an economy to fully regain its footing after a debt-induced financial crisis. If that is the case, the kind of normal economic expansion that we are used to seeing won’t take place until the fourth quarter of 2016. Mind you, this is not an economic forecast, but rather an alternative economic scenario.

Three things to keep in mind

So, what does all this mean for fixed income investors? Three things:

1. Don’t tie your asset allocation planning to a single economic scenario. Those investors who missed out on the bond market’s excellent performance in the first quarter were overly confident in the consensus that the U.S. economy was about to begin a robust expansion, and that interest rates were about to spike higher.

2. Interest rates will one day return to normal levels, but the adjustment process may play out over a longer period of time than most investors realize. Even though the Federal Reserve may raise short-term interest rates next year, there are other forces at work that could combine to keep interest rates low. Two in particular come to mind: rapid technological change, which is making the economy ever more efficient and productive, and demographics—in particular, the aging of the baby boom generation—which is slowing the growth rate of consumer spending, as baby boomers move well beyond their peak spending years. To put it simply, the supply of goods and services appears to be expanding faster than the demand for those goods and services, resulting in a structurally disinflationary economic environment that is supportive of both lower interest rates and higher bond prices.

3. If interest rates do adjust to normal levels over a period of years instead of months, bonds can still provide investors with a satisfactory return, as the coupon income generated by the bonds may be more than sufficient to offset any loss of principal caused by rising interest rates.

All these considerations suggest that bonds—far from being a short-term trade— should still be viewed as a core holding in a well-diversified investment portfolio, not only now but in the years to come.

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Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information.  Read it carefully.
The views and opinions expressed by Bob Brown are as of 4/7/2014 and do not necessarily represent the views of Fidelity Investments. Any such views are subject to change at any time based on market or other conditions and Fidelity disclaims any responsibility to update such views. These views should not be relied on as investment advice, and because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.
Neither Fidelity nor the speaker can be held responsible for any direct or incidental loss incurred by applying any of the information offered.

Past performance is no guarantee of future results.

Diversification/asset allocation does not ensure a profit or guarantee against loss.

Return data presented, source: Barclays Capital, Inc., as of March 31, 2014.

Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.

Foreign markets can be more volatile than U.S. markets due to increased risks of adverse issuer, political, market, or economic developments, all of which are magnified in emerging markets. These risks are particularly significant for funds that focus on a single country or region.

In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.)  Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.

Any fixed income security sold or redeemed prior to maturity may be subject to loss. Investments in mortgage securities are subject to the risk that principal will be repaid prior to maturity. As a result, when interest rates decline, gains may be reduced, and when interest rates rise, losses may be greater.

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