Skip to headerSkip to main contentSkip to footer
Get our Free E-newslettersGet our Free E-newsletters
Kiplinger logoLink to homepage
Get our Free E-newslettersGet our Free E-newsletters
Subscribe to Kiplinger
Subscribe to Kiplinger
Save up to 76%
Subscribe
Subscribe to Kiplinger
  • Store
  • Home
  • Investing
  • Retirement
  • Taxes
  • Personal Finance
  • Your Business
  • Wealth Creation
    • Podcasts
    • Economic Outlooks
    • Tools
    • Kiplinger's Personal Finance Magazine
    • The Kiplinger Letter
    • The Kiplinger Tax Letter
    • Kiplinger's Investing for Income
    • Kiplinger's Retirement Report
    • Store
    • Manage My E-Newsletters
    • My Subscriptions
Skip advert
  • Home
  • investing
investing

What's Driving the Boom in Bonds

When the unexpected happens, it deserves an explanation. Arguably, the biggest surprise in financial markets this year is the strong performance of bonds.

by: Carolyn Bigda
June 26, 2014

Thinkstock

Skip advert

When the unexpected happens, it deserves an explanation. Arguably, the biggest surprise in financial markets this year is the strong performance of bonds. You may recall that bond prices fell (and yields rose) last year after the Federal Reserve gingerly began to reverse its easy-money policies. With yields still near historically low levels, many seers expected more pain this year. But so far in 2014, the Barclays U.S. Aggregate Bond index, a measure of investment-grade debt, has delivered a total return of 3.9%. Other segments have done even better. The Merrill Lynch U.S. High Yield Master II index, a measure of junk-bond performance, returned 4.8% this year, and the Bloomberg USD Emerging Market Sovereign Bond index, a benchmark of U.S. dollar-denominated emerging-markets government debt, gained 8.3% (returns are through May 30).

The bond market has been able to outwit even the best investors lately. In 2011, for example, legendary bond investor Bill Gross famously dumped Treasuries in his Pimco Total Return fund, believing yields were due to rise sharply. That year, the Barclays U.S. Treasury index rallied 9.8%. And in 2013, Gross loaded up on Treasury bonds, just as the market was about to tumble. So while we can’t predict what’s next, we present eight questions and answers to explain the mysterious ways of the bond market.

Skip advert
Skip advert
Skip advert

1 of 8

Why Are Bonds on a Roll?

Thinkstock

Skip advert

So far this year, the yield of the benchmark ten-year Treasury has dropped from 3% to 2.5%, a large move by bond-market standards. The decline is due mainly to subpar economic growth. In fact, gross domestic product contracted at an annualized rate of 1% in the first quarter of 2014. Granted, the miserable winter weather accounts for some of that weakness, but the figure was well below economists’ forecasts of 1% growth. Normally, the ten-year Treasury’s yield approximates economic growth plus inflation. With inflation running a cool 1.4%, the bond market seems to believe there isn’t much need for higher yields, at least anytime soon. “Everything depends on the path that growth takes,” says Brian Kennedy, a bond fund manager at Loomis Sayles.

Skip advert
Skip advert
Skip advert

2 of 8

What Could Make the Market Change Course?

Thinkstock

Skip advert

By this point, bond prices and yields already reflect the effects of the Fed’s decision to gradually reduce and ultimately end its mammoth bond-buying program, which was designed to hold down interest rates. Yields could start rising again if economic growth kicks into higher gear—especially if warmer weather unleashes pent-up consumer demand, as some economists (including those at the Fed) predict. Indeed, Kiplinger’s forecasts that the U.S. economy will be expanding at a 3% annual pace by the end of 2014, and that the ten-year Treasury yield will return to 3% by the new year. But for yields to really surge, growth would have to accelerate even faster, or inflation would have to reach or exceed the Fed’s target rate of 2%.

Skip advert
Skip advert
Skip advert

3 of 8

If Yields Rise, Which Bonds Would Feel the Most Pain?

Thinkstock

Skip advert

Without a doubt, high-quality bonds such as Treasuries, government agency mortgage–backed securities and high-grade corporates—especially those with long maturities—would lose the most if yields rose sharply. Those bonds are the most sensitive to interest-rate moves.

Skip advert
Skip advert
Skip advert

4 of 8

How Big Could the Losses Be?

Thinkstock

Skip advert

That depends on the kind of bonds you own and how you invest in them. If you own individual bonds and hold them to maturity, you won’t risk losing your principal from interest-rate moves. But you will have to settle for earning less than you might make from newer bonds. And if rising rates are due to an acceleration of inflation, your bonds’ purchasing power at maturity will be less than you would have expected.

If you invest through a fund, you could see capital losses because the value of the bonds within the fund will fall as yields rise. How big those losses could be will depend on the average duration (a measure of interest-rate sensitivity) of the fund’s holdings. Say your fund has an average duration of five years. If yields rise by one percentage point, the principal value of the fund will decline roughly 5%. You can find the duration of your bond fund at Morningstar.com.

Skip advert
Skip advert
Skip advert

5 of 8

Do Some Types of Bonds Provide More Protection Against Rising Rates?

Thinkstock

Skip advert

Yes. The higher a bond’s interest “coupon,” the less the IOU is likely to lose in response to rising yields. That makes high-yielding junk bonds a good way to defend against a spike in yields. Junk bonds can also get a lift if rising rates are the result of an improving economy, which typically boosts the fortunes of high-yield-debt issuers. One positive sign for junk bonds: As of April, the global default rate for high-yield debt was only 2.4%, about half the historical average, according to Moody’s.

Unfortunately, these virtues have not gone unnoticed. Investors have been piling into junk bonds in recent years, pushing yields down to an average of 5.4% today, well below the long-term average of 9.6%. Plus, the narrow gap between junk and Treasury yields—2.9 percentage points—suggests that junk is pricey, if not overvalued. As a result, junk bonds’ biggest gains are probably behind them. Keep in mind, too, that junk bonds tend to track the stock market much more closely than high-grade debt. If the economy tanks, so will junk bonds.

Skip advert
Skip advert
Skip advert

6 of 8

What About Municipal Bonds?

Thinkstock

Skip advert

So much for their reputation for being sedate. Tax-free bonds are having a bang-up 2014, with the Barclays Municipal Bond index having returned 5.9% so far. A couple of factors are at work: Higher income tax rates boost demand for munis, which pay interest that is generally exempt from federal income taxes and, in some cases, from state and local taxes, too. Also, supply has been tight. Anthony Valeri, market strategist at brokerage firm LPL Financial, says issuance of new muni bonds in 2014 could be the lowest it has been in ten years. A supply-demand imbalance could help prop up munis over the longer term, too.

Still, munis are loosely tied to the Treasury market. If yields rise, muni bonds could stumble, especially given that they have become more expensive during this year’s rally. “Munis will not be able to ignore higher yields in Treas­uries,” says Valeri.

Skip advert
Skip advert
Skip advert

7 of 8

Are Foreign Bonds a Better Value?

Thinkstock

Skip advert

Overseas bonds can provide a good dose of diversification to a fixed-income portfolio. Trying to invigorate the euro-zone economy, the European Central Bank is more likely to cut already-low interest rates than to increase them. You’ll get more income and additional diversification if you invest in emerging-markets debt, but you’ll assume more risk. The Bloomberg USD Emerging Market Sovereign Bond index yields 4.5%, but it fell 6% last year. The Barclays U.S. Aggregate Bond index declined just one-third as much. And with any foreign bond fund, you have to think about the effect of currency swings on return. A strong euro has helped boost perform­ance. But if the currency weakens, U.S. investors would suffer as euros convert to fewer dollars.

Skip advert
Skip advert
Skip advert

8 of 8

Given the Risks, Should I Own Bonds at all?

Thinkstock

Skip advert

Bonds certainly have their perils these days, but they still play an important role in a portfolio. Treasuries provide a buffer against the gyrations of riskier assets, such as stocks. In 2008, for example, when the U.S. stock market plunged 37%, the U.S. Aggregate index returned 5.2%. Other types of bonds, including junk bonds and foreign debt, can boost your income.

Skip advert
Skip advert
Skip advert
  • wealth management
  • bonds
  • investing
  • Kiplinger's Investing Outlook
  • Investing for Income
  • Becoming an Investor
Share via EmailShare on FacebookShare on TwitterShare on LinkedIn
Skip advert
Skip advert
Skip advert
Skip advert

Recommended

Sometimes Renting Is Better Than Buying
investing

Sometimes Renting Is Better Than Buying

A home is an asset that generally appreciates in value, but it might not be the most optimal way to build wealth from an investment point of view.
May 25, 2022
Bond Values in a Volatile Market
Investing for Income

Bond Values in a Volatile Market

While the market's instability may not be over just yet, the latter half of the year should be less daunting – and possibly more rewarding – for inves…
May 25, 2022
The 12 Best Healthcare Stocks to Buy for the Rest of 2022
healthcare stocks

The 12 Best Healthcare Stocks to Buy for the Rest of 2022

Investors seeking out defensive plays in an uncertain market may want to take a closer look at these 12 top-rated healthcare stocks.
May 25, 2022
McDonald's (MCD) Stock: Tasty, Empty Calories
Investing for Income

McDonald's (MCD) Stock: Tasty, Empty Calories

For some, ESG challenges such as climate change and animal welfare offset the durability and dividends of MCD shares.
May 25, 2022

Most Popular

Retirement Income Shouldn’t Depend on the Market; It Should Depend on Math
retirement planning

Retirement Income Shouldn’t Depend on the Market; It Should Depend on Math

The math isn’t as tough as you might think. It all starts with dividing your assets into three different buckets.
May 23, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
Why Are Gas Prices Still Going Up?
spending

Why Are Gas Prices Still Going Up?

The cost of a gallon of gas is heading back toward its March highs. What’s driving the resurgence, and will gas prices go down anytime soon?
May 23, 2022
  • Customer Service
  • About Us
  • Advertise With Us (PDF)
  • Privacy Policy
  • Cookie Policy
  • Kiplinger Careers
  • Accessibility
  • Privacy Preferences

Subscribe to Kiplinger's Personal Finance

Be a smarter, better informed investor.
Save up to 76%Subscribe to Kiplinger's Personal Finance
Do Not Sell My Information

Kiplinger is part of Future plc, an international media group and leading digital publisher. Visit our corporate site www.futureplc.com
© Future US LLC, 10th floor, 1100 13th Street NW, Washington, DC 20005. All rights reserved.

Follow us on InstagramFollow us on FacebookFollow us on TwitterConnect on LinkedInConnect on YouTube