Long-term bonds go from outcast to on-top
New York • It took less than six months for some of the most feared investments to get investors to reconsider.
At the start of this year, much of Wall Street expected trouble ahead for long-term bonds. The bond market had just posted its first losing year since 1999, a result of rising interest rates. The conventional wisdom was that rates would only climb higher, and long-term bonds would bear the brunt of the impact.
But the opposite happened. Rates have dropped since January, and long-term bond mutual funds have been some of the best performers. Funds that focus on U.S. government bonds with an average maturity of more than 10 years have recorded an average return of 11.2 percent. That's the most among the 32 bond-fund categories that Morningstar tracks. Mutual funds that also own long-term corporate bonds have returned 6 percent. That's just ahead of stocks in the Standard & Poor's 500 index.
How'd they do it? Part of it was due to short-term factors. Tensions in Ukraine led to higher demand for safe investments like bonds, as did worries about a weak, polar-vortexed first quarter for the U.S. economy. But longer-term issues also were at play. Investors are debating whether the bond market is in a "new normal," one where interest rates will remain lower than before due to weaker growth, says Bob Jolly, head of global macro strategy for fixed income at Schroders.
But first, a reminder on some of the mechanics of bond mutual fund returns. Bond issuers make regular payments to their bondholders. Bond prices can also rise and fall, which affects total returns. When interest rates rise and newly issued bonds begin to offer higher yields, the price of existing bonds drops because their yields have suddenly become less attractive.
That's what happened last year. The yield on the 10-year Treasury note rose to nearly 3 percent from 1.76 percent in 2012. Long-term bonds are hurt more by a rise in rates because their yields are locked in for a longer time period. Investors yanked a net $1.8 billion from long-term corporate and government bond funds in the last three months of 2013.
But this year, the yield on the 10-year Treasury has dropped to 2.6 percent, and bond prices have rallied.
The biggest buyers of long-term bonds are pension funds, insurance companies and other institutional investors, says Thomas Chow, chief investment officer of corporate credit at Delaware Investments. They all have obligations to pay many years from now, and they want investments that will help enable them to do so and that aren't as risky as stocks. Foreign institutional funds have also been buying U.S. long-term bonds, Chow says, as yields here are higher than in Japan and Germany.
The performance of long-term bond funds this year has been strong enough to attract once-shy individual investors too. After several months of net withdrawals, long-term corporate and government bond mutual funds took in $717 million in net investment through the first five months of the year.
That has raised worries that expectations may be too high, though the pace of investment has slowed since April.
"I don't like to chase rallies," says Jim Kochan, chief fixed-income strategist at Wells Fargo Funds Management. "I would not go with very long-duration funds, I'd be more conservative."
He says managers that he works with have been selling longer-term bonds and replacing them with shorter-term bonds to limit the pain their portfolios would feel from a rise in yields.
Most fund managers ultimately expect interest rates to rise, notwithstanding what's happened so far this year. The economy is slowly strengthening, and employers added at least 200,000 jobs in each of the last four months. The Federal Reserve has cut back on its stimulus program to buy long-term bonds, which was an effort to keep interest rates low. Inflation is low now, but it could pick up, which would also push rates higher.
Jolly of Schroders expects yields on longer-term Treasurys to rise this year, which would hurt long-term bond prices. But he also says short-term rates could be a threat to rise faster than long-term rates.
The gap between them is wide: Long-term bond yields are higher than short-term yields, which are anchored at close to zero. Jolly sees that gap narrowing as the Federal Reserve moves closer to raising the federal funds rate, traditionally its main tool for influencing the economy, from its record low. The central bank also won't want longer-term rates to spike, because that would lead to higher mortgage rates and hurt the housing market's recovery.
Investors will get the latest clues on what the Federal Reserve is thinking this upcoming week. Its policy-making committee is scheduled to meet on Tuesday and Wednesday.