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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│sam@ansoncap.com│www.Ansoncap.com│
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