Investors ignored bonds during the late 1990s when interest rates were much higher than they are today. Now, with rates at historic lows, investors are flocking to bonds. Go figure. The reasons for the flight to bonds, evidenced by record inflows into bond mutual funds last year, are obvious:
- A grinding bear market for stocks has left investors looking for any positive return available anywhere.
- Bonds have rallied in the last three years as interest rates fell sharply.
Over the three years ended in February, the Standard & Poor’s 500 stock index fell by 44%. U.S. Government Bonds gained 39% during the same period.
Bonds have been in their own bull market for over 20 years. In 1981, interest rates on 10-year Treasury Notes hit 16%, the highest levels in 200 years. Rates at that time had been pushed up by the Federal Reserve to fight high inflation. The Fed won the war on inflation and cut rates over the following two decades.
As rates fall, bond prices rally because existing bonds with higher fixed rates become more valuable. Bond investors had a great ride over the period. During the 10 years ended in 2002 long-term government bonds returned 9.67% per year, with more than one-third of the gains coming from capital gains due to falling interest rates. Falling rates and capital gains were responsible for two-thirds of last year’s 18% gain in long bonds.
Investors snapping up bonds today based on their past performance are bound for disappointment, however. Interest rates are now at historic lows. Money market funds yield less than 1% per year, and 10-year Treasuries yield less than 4%.
Rates won’t drop much more, if at all. From now on, bond investors are looking at a best-case scenario of continuing to earn today’s low yields. The worst case is a rising interest-rate climate that pushes down the prices of current bonds.
Investors looking for principal safety for a portion of their portfolios should stick to short-term bonds. If rates rise, they will escape much of the pain and can redeploy money into higher rate bonds.