A Time to Take Stock in Your Bonds

Bond funds are rarely the topic of choice at the proverbial cocktail party, but they've been wildly popular with investors in recent years.

Inflows into taxable and municipal bonds totaled a staggering $870 billion over the past five years, according to Morningstar estimates. Of all the mutual fund categories that Morningstar tracks, meanwhile, none has seen greater growth in assets over the past five years than that of the intermediate-term bond-fund category, which drew in $304 billion in net flows since the end of 2006, more than doubling in size.

Some smaller bond categories grew at an even faster rate. The short-term bond category has grown more than 150% since 2006, for example, while the world-bond category--easily dominated by  Templeton Global Bond (TPINX), which comprises more than a third of its assets--has more than doubled in size over the period.

For investors who were simply looking to take some volatility out of their portfolios rather than hoping to outperform equities, the shift has worked out well. Most bond portfolios enjoyed a strong rebound as liquidity returned to markets that had been starved of it in 2008, and those with more interest-rate sensitivity picked up additional returns during 2011 as U.S. Treasury bonds rallied, particularly over the summer. The years since 2008's crisis have also proved profitable for most bond funds, although the average large-blend fund still maintains a strong lead with a 18% average annual gain for the past three years through Jan. 31 versus around 9.5% for the average intermediate-term bond fund.

There's Risk in Them There Hills 
While some of the shift can certainly be chalked up to demographic trends, growth among bond funds has been white hot. For many investors, bonds now comprise a much bigger slice of their portfolios, potentially leaving them more exposed to risks that had not otherwise been expecting. Front and center among these risks is the perennial concern that rising interest rates could drive bond prices lower. Right now, for example, there's strong reason to believe that short-term bond yields will stay low for an extended period because the Federal Reserve has signaled its intent to keep short-term rates there until late 2014. But while that may "anchor" the market level of short- and intermediate-term bond yields (as PIMCO has described their expectations), that still leaves pitfalls. Even if you buy and hold short-term bonds to maturity, even moderate levels of inflation are likely to produce so-called negative real returns. In other words, you'll get your money back, but the amount of income you'll earn on today's short-term bonds probably won't be enough to compensate for the loss in purchasing power that inflation will cause.

Meanwhile, the Fed's messages don't tell us much about what may happen among longer-maturity bonds. Of late, economic growth has been tepid enough to avoid any widespread panics about inflation that might spook the bond market, but those with exposure to the longest maturities have already felt a taste of what just a little good news can bring. The yield on the 30-year bellwether Treasury bond has bounced around over the past few months, touching a low of 2.76% in October, but overall has seen its yield go to 3.12% as of Feb. 10, 2012, on the heels of more positive news about the economy. On a total return basis, the long bond has shed more than 4% since the beginning of the year.

Most of the core bond portfolios that typically populate the intermediate-term bond category don't take on as much interest-rate risk as the 30-year Treasury, but as of the end of January, their durations recently averaged almost 4.9 years--up from four years in February of 2009--which is now just about in line with the commonly followed Barclays Aggregate U.S. Bond index. That figure implies that a 100-basis-point rise in market yields (that is, 1 percentage point) would be expected to produce a loss of roughly 4.9%. With 10-year Treasury yields currently hovering around 2%, it's easy to imagine that kind of pain--or worse--becoming a quick reality.

If You're Worried, You're Not Alone 
Managers of large funds at high-profile firms such as  PIMCO Total Return's (PTTRX) Bill Gross and  BlackRock Total Return's (MAHQX) Rick Rieder have both voiced concern about the risks of exposure to longer-term yields over the next year, though their overall portfolio approaches currently differ in response. Gross has been more vocally sanguine about the expected fortunes of intermediate-term bonds and has taken on more interest-rate risk globally, but both have talked about using long-maturity Treasury Inflation-Protected Securities as a hedge against the risk that conventional Treasuries might sell off if inflation fears kick up. (TIPS can suffer in the short-term if Treasury yields spike, but their principal will rise along with the Consumer Price Index.) It's impossible to know whether Gross and Rieder will prove right, but it's a helpful reminder that after a year that surprised many investors with a hot Treasury market rally, yields have sunk to historically low levels.

Meanwhile, both PIMCO and BlackRock have labored to expand their businesses over the past several years to make them less bond-centric and to offer more equity choices to their investors. They've done it in very different ways, but the message is clear: Both firms want to be prepared in case bonds' best days are behind them. BlackRock's CEO Larry Fink even surprised the market last week by declaring that investors should consider moving 100% into stocks.

Where to Turn? 
That said, the message here isn't necessarily that investors should be worried about rising yields and should therefore make a tactical shift out of bonds to protect themselves. It's a truism of bond management that consistently predicting interest-rate shifts is extremely difficult. Gross himself was famously wrong in expecting yields to rise last year, and he overcompensated for that in PIMCO Total Return, which badly trailed its benchmark. In addition, it's worth pointing out that the volatility of most core bond funds, even in a rising interest-rate environment, is apt to be substantially lower than what one would encounter in any type of equity fund.

Rather, it's simply a reminder that it still makes sense to stand back and re-evaluate one's overall asset allocation to make sure it's consistent with your long-term planning and goals. My colleague, Christine Benz, Morningstar's director of personal finance, looked at some issues around this topic in a recent column addressing investors whose worry levels have led them to favor bond allocations of 60% to 70%. Benz favors leaning on the Ibbotson research underpinning Morningstar Asset Allocation Indexes, though. Even the most conservative index--formulated for investors who are already retired and focused solely on income--allocate 43% in conventional bonds and another 25% to TIPS. A moderate allocation assuming retirement in 2020 has only 29% in bonds and 5% in TIPS.

If your bond allocations look significantly higher than those, and you have perhaps spent the last few years looking to escape the risks of the equity markets, it might make sense to take a careful look at your overall portfolios and ask whether being so heavily invested in bonds still makes sense given your long-term plans.