Six questions (and answers) about bonds

https://personal.vanguard.com/us/insights/article/bond-questions-052013

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Six questions (and answers) about bonds

MA Y 01, 2013

The Federal Reserve's unprecedented intervention in the U.S. bond market has stimulated more than the economy. Debate is raging over how fixed income investors will fare in the coming years. Kenneth Volpert, head of Vanguard's Taxable Bond Group, and Francis Kinniry, a principal in Vanguard Investment Strategy Group, fielded questions about the bond market.

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Are we in a bond bubble?

Ken Volpert: I don't think bubble is the right word. We are in an environment of financial repression, where monetary policy forces real yields (actual yields minus inflation) into negative territory to give governments and consumers breathing room to work off debt burdens. This deleveraging cycle is punitive to savers. However, the goal is for economies to get back on their feet as consumers and governments reduce red ink and more companies take advantage of low interest rates to increase business investments. The other side of financial repression is a stimulative "risk-on trade" that is intended to help lead us out of this cycle. Equities, corporate bonds, high-yield bonds, and many niche investments have benefited from the Federal Reserve's quantitative-easing (QE) policies, creating a wealth effect. The question is, what happens when the Fed reverses the flow of money, draining reserves from the system and pushing up interest rates? In essence, the Fed has pulled what would have been future gains into the present. The Fed's policies prevented the stock market from falling even further than it did in 20082009 and have accelerated the market's rebound. The trade-off is that once the Fed begins to unwind the QE stimulus, future returns are likely to be lower than they otherwise would have been for both bonds and stocks. More on the current bond landscape Yields aren't what they used to be, for a number of reasons. In a brief video excerpt from a recent webcast, Ken Volpert gives an overview of the financial and economic factors influencing yields and looks ahead to what's in store for bonds. Watch the video

Will bond investors be hurt when the Fed reverses its stimulative policies?
Ken Volpert: It depends on how quickly interest rates rise. The futures market for 10-year U.S. Treasury bonds is anticipating rates will rise 0.4 percentage point over one year, 0.7 over two years, and 1.1 over three years; in other words, a slow climb. The real yield on the 10-year Treasury is 0.7% now. If rates go up 1.1% over three years, that would bring the real yield to 0.4%, compared with a more normal level of 2.0%. Such a gradual risewhich is the goal of the Fed's unwindingwill depress bond returns but not into negative territory. If rates rise faster than the market is predicting, bond returns could turn negative. Just as financial repression

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Six questions (and answers) about bonds

https://personal.vanguard.com/us/insights/article/bond-questions-052013

has been bad for savers but supportive of economic growth, a return to positive real rates could create a drag on bond returns in the short term but compensate investors with higher yields over longer periods of time. Fran Kinniry: No one can say with certainty what will happen when the Fed slows or ends its substantial monetary stimulus programs. It is overly simplistic to say that if this happens, then that will happen. How markets react to the Fed's policy changes is driven largely by the reason for the changes and the degree of change, yet these factors are unknown. While much of the focus is on the bond market, the slowing or ending of the Fed's intervention could hurt equities and higher-risk investments more than lower-risk bonds. The bottom line is that the details that emerge as to why there is a change in policy will determine the outcomes for various investments.

Are real estate investment trusts, master limited partnerships, high-dividend stocks, and other high-yielding assets a good alternative to low yields in the bond market?
Fran Kinniry: Our research cautions investors against replacing a broad bond allocation with higher-yielding assets. While these may increase the portfolio's yield, they are more highly correlated with equities in market reversals, when investors are most in need of a cushion against volatility. A broad allocation to investment-grade bonds* has offered low correlation with stocks in bear markets, resulting in significant downside protection when stock returns were negative. That downside protection was greater, however, when bonds yielded 7.6%the average from 1976 to 2012. Today the broad bond market is yielding 1.9%, meaning the downside protection is not as strong; however, bonds remain one of the best diversifiers of equity risk. To understand the dynamic nature of asset class correlations and the implications in different market environments, I suggest a look at our research on the topic: Dynamic correlations: The implications for portfolio construction. Are bonds a good alternative to money market funds?

Are international and emerging market bonds a substitute for domestic bonds?
Fran Kinniry: The portion of the global investable market made up by international and emerging market bonds has grown significantly over the years. It increasingly makes sense for investors to consider adding hedged foreign bonds to their diversified portfolios. Many of the factors that drive international bond prices are relatively uncorrelated with the same factors driving U.S. bonds. Our research shows that, provided the currency risk is hedged, an allocation to high-grade international bonds in developed markets can lead to lower average portfolio volatility over time.

With yields at historic lows, it may be tempting to use a bond fund to manage your money. Find out why even a small increase in interest rates could reduce the value of your cash position. Learn more

If investors are concerned about rising interest rates, where do they go for protection?
Fran Kinniry: Investors shouldn't confuse today's low level of rates with the future direction of rates. No doubt rates are low, so returns will be lower, but the future direction of rates is uncertain and not correlated with the current low rate levels. The interesting question is, protection from what? If investors are trying to make a call on the forward returns of stocks versus bonds, they are going to have to get a lot of things right. For example, how will each asset class move relative to the other? And by what degree? There is also the matter of when these moves will begin and when they will end. Vanguard has consistently advocated the value of an all-weather, well-diversified portfolio in lieu of attempts to time the market, which have historically proved futile. Many have been calling for rising rates for a decade, so it's important to remember that reacting to headlines can be harmful to your portfolio.

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Six questions (and answers) about bonds

https://personal.vanguard.com/us/insights/article/bond-questions-052013

What is the bottom line for investors?

Ken Volpert: The Fed's stimulative policies of recent years will be a headwind to growth going forward when the Fed will need to unwind its quantitative-easing buys by actively selling the bonds or by passively letting them mature. It may take a long time for the yield curve to normalize (the curve will slope upward from short-term bonds to longer-term issues), but that will be necessary to prevent excesses and asset bubbles that harm investors. The key is to use times when there is market volatility to rebalance your portfolio to your long-term stock/bond mix. This will lead you to sell the better-performing asset class and buy the weaker-performing one. Fran Kinniry: I would suggest revisiting your situation from the fall of 2008 (when stocks were sinking) and the late winter of 2009 (when they were climbing). Rather than focusing myopically on the spring of 2013, remember the emotions you felt in the good times and the bad. If you committed to an asset allocation appropriate for your time horizon and risk tolerance, your job now is to stay the course. The right allocation is having as much equity as possible but never so much that you aren't willing to stay committed to the allocation, including the discipline to rebalance in the worst of times.
*Those whose credit quality is considered to be among the highest by independent bond-rating agencies.

Notes: All investments involve some risk. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss. Past performance is no guarantee of future results. Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline. High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings. Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.

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