The three-decade bull market in Treasury bonds had to end sometime, and 2013 marked a major inflection point between bull and bear.
In 1981, the benchmark 10-year U.S. Treasury bond yielded 14 percent; difficult to imagine considering the low-yield world we’ve been living in during the past decade. But from that high-water mark, inflation expectations steadily declined over the next 30 years, accompanied by a sharp decline in interest rates.
Ten-year bond yields hit a low of 1.7 percent in May 2013 amid fears of yet another economic slowdown and with little inflation in sight. But then Federal Reserve Chairman Ben Bernanke uttered the infamous five-letter word: t-a-p-e-r … and it didn’t take long for the interest-rate trend to reverse with a vengeance.
|Bonds can still play an important role in your portfolio to diversify your asset mix, and provide a stable source of income in retirement.|
Although the Fed is just beginning the long process of normalizing interest rates, bond yields shot up to 3.03 percent by the end of 2013, a breathtaking increase of 76 percent. Bond prices, which move in the opposite direction of yields, plunged last year, posting the worst performance since 2009.
It’s no surprise that bond funds suffered $111 billion in outflows during the second half of 2013 (through November), the most consistent bond fund redemptions since before the financial crisis in 2008.
So far this year, bond prices have bounced a bit higher as jittery investors shift money into “safe haven” investments with the S&P 500 Index down 5 percent. But at this point in the economic cycle, Treasury bonds are neither safe nor a haven.
Unfortunately, too many investors could be unprepared for this epic interest rate shift.
Now that interest rates have likely hit bottom after reaching generational lows, it’s only a matter of time before investors, who flocked to the “perceived safety” of bonds over the past decade, decide to pull trillions of dollars out of bond funds and ETFs, pressuring bond prices.
Typically, investors are slow to react at key market turning points by shifting their personal asset allocation. That’s why mutual fund flows follow performance rather than lead it.
But with interest rates still near record low levels today, fixed-income investors need to be proactive about considering changes now.
After all, there remains $3.6 trillion in fixed-income mutual fund and ETF assets earning very low yields today. That’s a lot of potential outflows to pressure interest rates higher in the years ahead.
If you hold fixed-income investments in your portfolio, here are three factors to consider. I’ll tell you about one today and two tomorrow, so please stay tuned:
1. Have realistic expectations: Rising rates are bad for bonds, as investors found out the hard way in 2013. However, bonds can still play an important role in your portfolio to diversify your asset mix, and provide a stable source of income in retirement.
Just don’t expect bonds to provide the kind of returns they did over the past decade. Investment-grade corporate bonds returned an average of 10 percent annually over the past 30 years, just a hair less than the 12 percent average annual gain for stocks, but those days are likely over.
Those outsized returns resulted from the favorable tail-wind of steadily falling interest rates that isn’t likely to repeat.