Prepare for a Mild Pullback in Bonds

There's more to this picture than the direction of interest rates.

I’m about to do what some of my longtime readers might ridicule as an about-face and a few will denounce as a betrayal of my core convictions. For the first time in this decade, I am forecasting negative total returns for bonds, on average, over the next several months and probably for all of 2018.

Before you faint, I am not abandoning my view that interest rates will stay “lower for longer,” nor am I suggesting that your portfolio will suffer severe damage. But bonds are now expensive, and 2017’s excellent returns appear to have borrowed some gains from 2018. So I predict, for reasons I’ll get to, a roughly 2% net loss (that’s principal losses reduced by interest payments) for 2018 on a broad portfolio of bonds of varying maturities and credit types.

First, though, I reiterate that the low-stress financial climate we’ve enjoyed since the Great Recession will persist. Low inflation, range-bound interest rates and U.S. economic growth will steer the same steady course over 2018 as they have over the past few years. So, then, why do I think bonds are due to backtrack? My reasons are a mite wonkish. But hear me out.

Rates aren’t the whole story. Bonds make or lose money in several ways. Swings in interest rates get the most attention, though rate action tends to have the most effect on Treasury bond prices. (Normally, when rates rise, bonds already in circulation lose value.) Kiplinger thinks that the rate on 10-year Treasuries will end 2018 at 2.8%, up from 2.4% expected at the end of 2017. But there’s more to bond returns than the rate trend. Most critical is the gap, or “spread,” between Treasury yields and those for municipals, corporates, high-yield “junk” bonds, emerging-markets debt, mortgage pools, preferred stocks, and sometimes even real estate investment trusts and energy partnerships. When spreads are narrowing, it means those categories are delivering higher returns than Treasuries—and of late, ever-tighter spreads have inflamed bond returns.

A year ago, the average investment-grade, triple-B-rated corporate bond yielded 1.7 percentage points more than Treasuries of the same maturity. Now, triple-Bs yield one percentage point more—a big reason why triple-B bonds show a superb 6.5% return for 2017 through October 31 compared with 2.1% for 10-year Treasuries. Spreads on junk bonds range from 5.2 percentage points to barely over 3, which is about as close to Treasury yields as you’ll ever see for junk. High-yield bonds have an average year-to-date 2017 return of 7.5%. But now, the extra yield you’d receive for taking the greater risk of investing in lower-rated non-government debt is so small that even bond bulls doubt spreads will narrow further.

This segues to the next reason for caution: supply and demand. In 2017, despite the healthy economy, new issuance for every kind of bond, taxable and tax-free, fell from 2016 levels. Yet investors are pouring fresh money into bond mutual funds, exchange-traded funds and institutional fixed-income accounts. This shortage of debt securities pushes up prices, tightens spreads and contributes to strong total returns. But now I see forecasts that 2018 issuance will rise, or at least stop falling.

A new Federal Reserve chairman is a wild card for the fixed-income market, although the consensus is that after the appointment of Jerome Powell, monetary policy won’t stray far from the path it’s on now.

In sum, should you sell? In most cases, the answer is no, especially if you bought a bond or invested in a fund for the income and you would owe capital gains taxes. If you think you can finesse the market by selling an appreciated bond or bond fund, holding the cash for a bit, then reinvesting for a higher yield, ask yourself if you’ve ever aced such a tactical trade with stocks (or anything else). It’s tougher in practice than in theory. For most investors, a better course of action in 2018 is to sit tight and collect your interest.

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