The Next Bear Market

Is the bond market the next bubble waiting to burst? Investors certainly have been pouring money into bonds and bond funds, just as they bought technology stocks and funds near the top of the market.

The new-found attraction for bonds is understandable. They have had a 22-year bull market. As stocks tanked, the most popular bond index returned 11.6% in 2000, 8.4% in 2001, and about 8% in 2002.

Yet, the best of the bond bull market clearly is behind us. Those who expect similar returns in the next few years are apt to be disappointed and might even suffer losses. Clearly, lower expectations for bond returns are in order. The 10-year treasury bond yields 4% to 5% now, and that yield is the most investors should expect from treasury bonds the next few years. GNMAs and other mortgages yield a bit more, and that yield is all the returns investors should expect from them.

It won’t take much to lose money in treasury bonds. If the 10-year yield rises from 4% to 5% in one year, it will generate a 3.2% loss for the year. Meanwhile, money market funds yield around 1%, which means you lose money after inflation and taxes.

As the economy grows, inflation expectations should rise a bit. That will push up interest rates. Economic growth also should increase the demand for loans, which means higher rates. I’m not forecasting 1970s-style interest rates. A relatively small rate increase, however, will sink bond returns.

What is a bond investor to do? Bond investing has to change in this new environment. In my view, the investments that traditionally are the safest (treasury bonds) now carry the most risk. Here’s what to do.

• Bonds will trade in a range as interest rates fluctuate from 4% to 6% over the next few years. If the current yield is high enough for you, and the intermediate fluctuations in principal don’t bother you, stick with your current bond investments. Keep in mind that the bond cycle new is at its high point and it could be quite a well before bond prices are as high as they are now.
• Reduce holdings of treasury bonds and GNMAs. Because of the flight to safety the last two years, treasury and mortgage yields are too low to provide enough income for most people, and better values are available in other types of bonds. Each type of bond will lose value as interest rates rise.
• Rethink bond index funds. I’ve advocated these for several years, because few active bond funds beat the indexes. It looks like that is changing. The indexes are harder for the funds to replicate. Also, the indexes are riskier. They hold fewer treasury bonds, carry higher risk, and have a much lower duration than just a few years ago. Active bond funds are likely to be a better deal in the future. I still believe PIMCO Total Return is among the best. You can get the same fund manager, Bill Gross, for lower fees through Fremont Bond.
• Add inflation indexed bonds to your core. With Treasury Inflation Protected Securities (TIPS), price inflation is offset with an increase in principal value. I expect TIPS to perform better than regular treasury bonds for a few years. They are best owned through a tax deferred account, because the inflation indexing is taxable each year. Consider the inflation-indexed bond funds from Vanguard, American Century, and PIMCO. I’m not adding them to the recommended portfolio, but they are a good alternative for treasuries.
• Invest in corporate bonds and high yield bond funds. Investors ran from these the last two years, and now their yields are historically high compared to treasuries. With corporates and high yields, you will get a higher yield than from treasuries and will get capital gains as the economy improves and the accounting scandals become unpleasant memories.
• Take a look at international bonds and emerging market bonds. International bonds are returning to the Income Managed Portfolio as a hedge against the dollar and their attractive yields. Emerging market bonds still carry more risk than I care to put in the portfolios. They might become attractive if Latin American economies improve, and some of you might want to take the risk now.

The PIMCO Total Return and Fremont Bond funds implement many of these changes on their own, so retain them as the foundation of the Income Core Portfolio. If other funds are in your Core Income Portfolio, consider a change. In the Managed Portfolios, I’m reducing the GNMA funds and increasing corporate bonds and high yield bonds. See page 10 for details.

I know many of you are interested in preferred stocks for income. I’ll discuss them in an upcoming visit.