Oh, right. Stability. That's what bond mutual funds are for.
When stock markets tumbled around the world last week, bond funds remained solid once again. They continued to inch ahead, while stock indexes swung up and down by more than 1 percent for five straight days. So many investors poured money into bonds in search of safety that the yield on the 10-year Treasury note temporarily dropped below 2 percent for the first time in more than a year. Yields for bonds drop when demand increases and their prices rise.
It's a reminder of the value of bonds in a diversified portfolio. But it's also important for anyone moving into bonds to keep expectations in check following their decades-long run of strong returns. Yields are lower, risks are higher and it may be difficult for bonds to replicate the returns they've produced this year. Here's a look at what to expect:
— BOND FUNDS MAY MAKE MONEY IN THE NEXT YEAR, BUT NOT MUCH.
Many bond funds have returned about 5 percent this year. Managers call that a good year, even though it would rate as a ho-hum return for stocks.
The reason is that bonds don't pay much interest. Many bond funds benchmark themselves against the Barclays U.S. Aggregate index, and it has a yield of 2.15 percent. That's down from 2.50 percent at the start of the year, and it's roughly half of what it was a decade ago.
Bond funds have benefited from a drop in interest rates this year. When that happens, it makes the yields of existing bonds more attractive and pushes up their value. So bond fund investors get returns both from payments made by the bonds and from rising prices for the funds.
Over the next 12 months, interest rates are unlikely to drop much further, says Roger Bayston, senior vice president of Franklin Templeton's fixed-income group. That means returns for bond funds will come mostly from their interest payments. The 10-year Treasury note's yield is below 2.3 percent, but riskier bonds from companies with poor credit ratings can offer yields of about 6 percent.
Bayston is a manager atop the $4.9 billion Franklin Total Return fund, which invests in a wide range of bonds from Treasurys to foreign bonds to high-yield "junk" bonds. Bayston says he's still finding opportunities, including in mortgage-backed securities.
— BOND FUNDS ARE MORE STABLE THAN STOCKS, AND WILL LIKELY CONTINUE TO BE ...
An example of that stability is the last month. The average intermediate-term bond fund, which forms the core of most bond portfolios, has returned 1 percent. The largest category of stock mutual funds has lost 3.7 percent over the same time.
Bonds are promises by companies to repay loans with interest. As long as companies don't default, bondholders will get their promised money. And default rates are low due to how much cash companies are holding, how quickly their earnings are growing and how low their interest payments are.
"If you have a five-year bond, five years from now, you will have cash whether you want it or not," says Jeff Moore, co-manager of Fidelity's $16.1 billion Total Bond fund. "If you own a stock, five years from now, you have the stock."
In the last 30 years, the Barclays U.S. Aggregate index has had a loss just three times. The worst was a drop of 2.9 percent in 1994. Compare that with the Standard & Poor's 500 index, which lost 37 percent in 2008.
