What, Vanguard Worry About a Bond Bubble?

Bond funds are climbing a wall of worry, but Vanguard contends that diversified, long-term investors may not have much to worry about.

A thicket of red flags flies over fixed-income funds--strong trailing returns, hot inflows, and suspect valuations in some bond sectors--yet they've continued to best other broad asset classes and attract investor dollars. Taxable-bond funds are beating both domestic- and international-stock funds so far this year, rising nearly 6% versus about 3% for U.S.-equity funds and less than 1% for foreign-stock funds. The performance edge, which extends over the three-, five-, and 10-year trailing periods, has attracted money. For the year to date through the end of June, taxable-bond funds have taken in nearly $120 billion, compared with $16.5 billion in outflows for domestic-stock funds.

The performance and flows persist even though the broad bond market's historically low yields implies skimpy returns at best. ( Vanguard Total Bond Market (VBMFX) yields less than 3%.) Gluttonous developed-markets government debt also presages inflation and interest-rate hikes at some point down the road, and both are anathema to fixed-income investors. Bonds will disappoint those expecting a repeat of the past decade. Even Bill Gross, manager of the giant  PIMCO Total Return (PTTRX), has said that bonds' best days may be in the past. That's why some argue investors have to get more tactical to eke out some kind of income and total return. They either have to take more interest-rate risk in the bonds of more fiscally prudent countries or assume more credit risk on individual issues or consider high-yielding stocks, such as drugmaker  Eli Lilly (LLY), which has a more than 5% yield, but also some company-specific and equity-market risk.

An individual investor's inner contrarian might argue that if bonds are what everyone wants despite their history and fundamentals, perhaps one should avoid bond funds altogether. Vanguard, however, has contended in a number of articles, interviews, and research papers posted on its website and on Morningstar.com that the contrarian view may actually be to stick with a diversified bond portfolio. Here are some of the family's reasons summarized.

Not Armageddon
Bonds' future may not be a total disaster. In its first-ever published annual economic and capital markets outlook, Vanguard conceded that current low yields don't look like much. Still, even the worst 10% of expected fixed-income returns over the next 10 years is positive, according to firm's forecasts, which involved modeling thousands of different scenarios. In Vanguard's simulations, investment-grade corporate bonds do a bit better on average than U.S. government issues and Treasury Inflation-Protected Securities lag other Treasuries. The family estimates there's a better than 20% chance of the total bond market earning 3.5% to 4% over the next 10 years and a less than 5% probability of it gaining less than 2%.

Makeup Call
Even if a bond bear market rears its head, you may be able to recoup losses over time. If interest rates rise, as many (including Vanguard) expect they will eventually, bond prices will fall and investors could lose money in the short term. Rising yields, however, can offset those losses by giving investors opportunities to reinvest their interest distributions at higher rates of return. In a simplified, hypothetical illustration in a recent paper on bond allocations and rising rates, Vanguard estimated that even if rates rose by 4 percentage points in one year, something they've done only twice in U.S. history, a Total Bond Market investor would suffer harrowing losses in the first year after the hike but would be close to breaking even two to three years later by reinvesting distributions and holding tight.

Teddy Bear
A bond bear market likely will not be as fierce as a stock bear. The common definition of an equity bear market is a decline of 20%. So far in U.S. history, bonds have never fallen that far. The worst 12-month return for U.S. bonds since 1926 was 9.2%. That hurt, but not as much as the worst 12-months for domestic stocks--a nearly 68% loss in the year ended June 1932. Just because it never has happened doesn't mean it won't, but there's a very low probability of a bond bear market being worse than a stock bear market.

Bear Trainer
Diversification can tame a bear somewhat. Vanguard looked at how U.S. bond, stock, and balanced (60% stock/40% bond) portfolios have behaved over time in response to short- and long-term rates hikes of more than 2 percentage points in a year. It found that, on average, all three portfolios posted positive results in the same 12 months in which the rate change took place, and in the subsequent 12 months. After adjusting for inflation, only the following 12 month's returns tended to be positive. The firm found similar results looking at portfolios in nine foreign developed markets, though international-stock investors were more likely to lose money in the year in which rates rose than their domestic counterparts. Vanguard's conclusion: "A reasonable investment strategy should not be abandoned in the face of a potential bond bear market, whether driven by inflation or some other market force."

Takeaways
Vanguard has some interest in convincing people to stay the course in their bond funds. The family has taken in more than $45 billion in taxable-bond inflows in the past year and has more than $300 billion in bond funds overall. Yet, the family's research offers valuable perspective. In the face of low yields and great uncertainty, there is a fierce temptation to do something, anything to improve results or prepare for the unknown. That can lead one to chase yield and performance, which never works out; or withdraw to a money market fund or savings account, which won't get you to your goal. If you view the bond portion of your portfolio as volatility-moderating ballast, the best course of action may be the old course of action: Stay diversified and on plan.

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