What's Driving the Boom in Bonds

Why Are Bonds on a Roll?

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.

What Could Make the Market Change Course?

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%.

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

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.

How Big Could the Losses Be?

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.

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

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.

What About Municipal Bonds?

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.

Are Foreign Bonds a Better Value?

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.

Given the Risks, Should I Own Bonds at all?

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.