Buying Bonds Is Yesterday's Story

02/10/2010 1:00 pm EST

Focus: MARKETS

Christine Benz

Director of Personal Finance, Morningstar, Inc.

Christine Benz of Morningstar explains why chasing yield and performance is a bad idea, and lays out some reasons bonds may underperform in the coming decade.

The most common [mistake investors make] is what we at Morningstar call “driving with the rearview mirror,” or buying what has been hot in the recent past in the hope that its performance streak will continue. Such performance chasing rarely works.

Unfortunately, good old-fashioned performance chasing was alive and well in 2009. While stocks staged a monster rally that began in early March, investors demonstrated a clear preference for bonds, a (relative) safe haven in 2008.

Open-end bond mutual funds (both taxable and municipal funds) raked in $357 billion in new investor assets during 2009. Flows into equity funds, by contrast, were roughly flat for both traditional mutual funds and ETFs in 2009.

Looking forward, bond investors face a few different possibilities, none of them especially appealing. If the economy continues to recover, inflation could rear its head and interest rates could head up in a hurry. Under that scenario, bonds, particularly longer-term ones, will see their prices get depressed.

A useful rule of thumb is that with each percentage-point increase in interest rates, a bond fund will lose an amount roughly equal to its duration, a measure of interest-rate sensitivity. So, if a fund has a 12-year duration, as Vanguard Long-Term Bond Index (VBLTX) had as of mid-January, it could shed 12% of its value if rates jumped up by just one percentage point.

Intermediate-term and certainly short-term bonds wouldn’t suffer as much, nor would they be bulletproof. Vanguard Total Bond Market Index (VBMFX), for example, has a 4.5-year duration currently, which would translate into a roughly 4.5% loss with each percentage-point increase in rates. Those rising rates would eventually translate into higher bond yields, but the process would be painful for current bond-fund holders.

If the economy picks up and the Federal Reserve doesn’t act to keep a lid on inflation, higher prices for goods and services could gobble up every bit of yield that investors are able to earn. Bond investors are barely outearning today’s meager inflation rates.

Finally, it’s possible that both inflation and interest rates could remain low for the foreseeable future—a likely outcome if the economy fails to mount a lasting and convincing rebound. Bonds wouldn’t get hurt under that scenario and may in fact be a safe haven if market participants decide that stock prices reflect overly rosy expectations.

There’s nothing wrong with building a fixed-income portfolio that’s in line with your target allocation, battening down the hatches, and not worrying about modest fluctuations to your principal value. If you employ such a hands-off approach, you can take comfort in the fact that higher interest rates will eventually translate into higher take-home yields, even if the process causes some disruption along the way.

But if you’re making the bet that bonds will be appealing in the future, it’s important to understand what a gloomy wager you’re making.

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