AOTW 2014 0129

Our article comes from The Wall Street Journal this week and takes a look at a new era in the bond market.


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How You Can Survive a New Era in the Bond Market

Think High-Dividend Stocks, International Bonds and 'Junk' Bonds

For investors, last year's losses in the bond market should serve as a wake-up call that the era of big bond-market returns is over. For the foreseeable future, many say meager returns and occasional losses will be the norm.

With the Federal Reserve having pushed interest rates to record-low levels to boost the economy, bond-market math means returns for the next five to 10 years should be in the low single digits at best, market pros say.

That doesn't mean investors should abandon bonds. That's especially the case for those, such as retirees, who need to protect their portfolios against significant price swings.

But for many investors, particularly those with very long time horizons, it may call for notching down the level of U.S. government bonds in favor of higher-returning investments, including conservative stocks, even if that means greater short-term ups and downs in a portfolio.
Jason Schneider
Worst Loss in 19 Years

Last year, the Barclays U.S. Aggregate Bond Index, the most commonly used benchmark for the bond market, lost 2.1%. That marked its first decline since 1999 and the worst performance since 1994.

"2013 is a taste of what we may be seeing the next couple of years," says Shawn Rubin, a financial adviser at Morgan Stanley.

The problem is essentially that interest rates had been pushed so low by the Fed that there is nowhere to go but up. Bond prices and yields move in the opposite direction.

This marks a sea-change for bond investors who have enjoyed a bull market going back more than three decades.

From 1981 through 2012, the Barclays Aggregate index posted an average annual total return of 8.9% a year. During that time, stocks in the S&P 500 index returned 12% including dividends. More recently, from 2000 through 2012, bonds returned 6.3% while stocks returned 3.5%.

How bad will things be from here? A rule of thumb is that investors can estimate future returns based on current bond yields.

Wesley Phoa, an economist and portfolio manager for American Funds, does the math using the U.S. Treasury 30-year bond yield, which is currently just south of 4%.

If bond yields continue rising toward a long-run average of 4.5% or 5% in coming years, as the economy continues to recover, that would mean losses on 30-year bond prices of some 15%, he says.


With that paper loss on the bonds offsetting the slim payouts from the bonds, "you might get a 3% [total] return for long-term Treasurys," Mr. Phoa says. "You are going to earn substantially less than on stocks."

Vanguard Group has an even more muted forecast, predicting broad bond-market returns in the 1.5% to 3% a year range, says Joe Davis, head of the firm's investment strategy group. For investors whose financial plan calls for earning 5% or 6% on bond returns through a conservative portfolio, "that's going to be almost mathematically impossible."

Tweaking Target Funds

As a result, he says, "a conversation we are having much more frequently is 'If returns are going to be much lower, what do I do?' "

One answer can be seen in shifts made last September by Fidelity Investments in its target-date funds, which offer a mix of stock and bond investments tailored to different ages.

Fidelity's Freedom Funds lineup lowered its bond holdings across the board and increased stock weightings. For example, the Fidelity Freedom 2020 fund (FFFDX)—aimed at those retiring that year—lowered its bond-fund stake to 30% from 39%.

However, Andrew Dierdorf, co-portfolio manager on the Freedom Funds, stresses that bonds remain an important holding.

"While return expectations may be lower, the diversification and risk protection [from bonds] can still be very important, especially as investors get older and their time horizon gets shorter," he says.

That sentiment is echoed by Jerome Clark, a portfolio manager of target-date funds at T. Rowe Price Group, which tend to have higher allocations to stocks than many other firms on the belief that longer life expectancies call for heavier doses of higher-returning assets.

Even as T. Rowe target-date funds lowered allocations to U.S. bonds in recent years, the company has kept weightings within five percentage points of each fund's baseline, Mr. Clark says. "We don't want to offset the benefits of the strategic allocation."

Diversity Among Bonds

That said, T. Rowe has been tilting the portfolios toward bond investments that are going to move less in lock step as U.S. interest rates rise, such as international bonds, including emerging markets, and high-yield bonds.

Chip Castille, head of the U.S. retirement group at BlackRock, says the new bond environment calls for a different approach to building a portfolio. During the multi-decade bond rally, investors could get high returns, diversification and a cushion against big portfolio swings all in one place. Now, he says, "you have to get those characteristics in different places."

An investment pegged to a broad U.S. bond index such as the Barclays Aggregate still provides diversification, he says. But for better returns, he suggests so-called go-anywhere bond funds, which roam the world for bond investments and can make bets that profit from falling bond prices.

At the same time, he suggests investors consider so-called low-volatility stock funds, which own defensive, higher-yielding stocks. Those funds, he says, can generate higher returns without exposing an investor to the kinds of price swings seen in broader-based stock funds.

Ironically, while last year's U.S. bond-market selloff dented investors' portfolios, the rise in yields from 1.76% to nearly 3% on the U.S. Treasury 10-year bond boosted the potential return profile from bonds for those putting new money to work. T. Rowe Price has actually notched back up some bond holdings from a year-ago levels.

Morgan Stanley's Mr. Rubin notes that yields on some longer-term municipal bonds are getting within shouting distance of a 5% tax-free yield. In general, he is holding fewer bonds for clients than would otherwise be the case. But at those kinds of yield levels, for investors with a long-term time horizon who can stomach price swings, "I'm going to own a lot of munis."

Sam Sweitzer, CFA │Principal│ANSON CAPITAL, INC.
o: 678-216-0795│f: 877-750-9088│[email protected]││

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