Bonds offer less upside in this market downturn
Stock prices are crumbling around the world, but the usual place for investors to go for safety, bonds, can’t provide as much cover as usual.
Bonds are still doing their job as investors’ best friends during a downturn: They’re holding up better than stocks, cushioning the blow for balanced investors. High-quality, investment-grade U.S. bonds had returned 0.9 percent through Wednesday, while the Standard & Poor’s 500 index has lost 7.4 percent on worries about the strength of the global economy.
The problem is that bonds are not doing as good a job as in past downturns, and the outlook for them is dim. Super-low interest rates mean bonds don’t pay investors much for the bonds they hold or are buying. And those bonds may fall in price in the coming months and years if interest rates rise as the Federal Reserve, as expected, continues to move short-term rates higher.
“It’s just basic math,” said Chris Philips, head of institutional advisory services at Vanguard. “We’re at different levels today, and bonds don’t have as much room to grow on the price side.”
That means it will take longer for most investors — even those with a balanced mix of both stocks and bonds — to recoup all their losses from this downturn for stocks.
The diminished expectations for bonds have investors looking for alternatives to protect their portfolios in case stocks keep falling. But financial advisers and mutual-fund providers say investment-grade bonds, known also as fixed-income investments, are still among the best options because the alternatives carry risks of their own.
Stock funds that track the S&P 500 have lost 10.1 percent since setting a record high on May 21. Bond funds have largely held steady over that time, good enough to trim overall losses for balanced investor’s portfolios.
But unlike in past downturns — when bond funds were offering healthy returns — the protection provided this time has been only modest. The largest bond mutual fund, Vanguard’s Total Bond Market Index, has returned 0.8 percent in the nearly eight months since stocks began their tumble.
That same fund returned many times more than that — in a shorter time period — the last time stocks had a slide big enough for market watchers to call it a “correction.” The Total Bond Market Index fund returned 5.3 percent in just over five months when the S&P 500 was in the midst of losing 18.6 percent from April 29, 2011 through Oct. 3, 2011.
Perhaps the best example of how bonds have protected investors is the financial crisis of 2008. Bonds helped balanced investors recoup all their losses long before stock-only investors got back to whole, nearly two years in some cases.
The big difference between now and then is that interest payments on bonds are half what they were. A 10-year Treasury note had a yield of 4.65 percent in 2007, when stocks hit their peak before the Great Recession. It was at just 2.09 percent Wednesday.
Now the Fed is in the process of raising rates. That may help future bond investors by offering a better rate of return, but the bonds they hold or buy now looking for safety could become less valuable. Prices drop for existing bonds when rates rise because the new, higher-yielding bonds are more attractive.
Mutual funds that use hedge-fund-like strategies to try to offer steadier returns, called “liquid alternative” funds, have proliferated in recent years, but they can charge high fees and many have limited track records.
High-yield bonds, also called junk bonds, offer higher payouts than traditional investment-grade bond funds. But they’re issued by companies that have a greater chance of not making good on their debt.
The professional investors who manage the popular mutual funds that target specific retirement dates are sticking with investment-grade bonds, despite the muted forecasts.
Many strategists say investors just need to get used to lower returns, not only from bonds but also from stocks, following their big gains in recent years.