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Resilient Bond Funds for a Difficult Market

During the past five years, intermediate-term bond funds have delivered solid results, returning 5.6% annually, according to Morningstar. Will the performance be as healthy in the next five years?

Probably not, says Jeremy DeGroot, chief investment officer of Litman/Gregory, which publishes No-Load Fund Analyst, a respected newsletter. DeGroot figures that the Barclays Aggregate Bond index will return 1% to 2% annually.

He bases the forecast on the assumption that the Federal Reserve's efforts to flood the economy with cash will succeed. The economy will improve slowly, and the demand for loans will increase. That will help to boost interest rates. In a likely scenario, rates on 10-year Treasuries will rise from the current 2.5% back up to 4.0%, a level that last occurred in October 2008.

When rates rise, bond prices tend to fall. But results will stay in the black because bond total returns come from two sources: nterest income and rises in bond prices. In coming years, higher interest income will help to compensate for declines in bond prices, and total annual returns should approach 2%. If interest rates climb to 6%, a figure that is near the historical average, then bond investors would receive 1% total returns.

DeGroot concedes that his forecast could prove off the mark. But under any likely scenario, bond returns will be modest. For example, if rates drop to 1.5%, funds would produce capital gains, but total returns would only be 3%.

In this difficult environment, plain-vanilla bond funds will deliver meager results, DeGroot says. The typical intermediate-term bond fund roughly tracks the Barclays Capital Aggregate bond index, a high-quality benchmark. Treasuries and other AAA-rated securities account for three quarters of the assets in the index. When rates rise, prices of such high-quality issues can sink sharply.

For better results, consider lower-quality issues, says DeGroot. The low-quality issues often prove resilient in difficult markets, especially during periods when rates are rising because the economy is growing. At such times, investors often bid up prices of low-quality issues since there is less fear of defaults.

With the outlook cloudy, should you avoid investment-grade bonds altogether? No, says DeGroot. While investors should underweight high-quality bonds, they should hold at least some investment-grade issues. "Investment-grade bonds can help to diversify a portfolio, and that is important at a time when the economy faces headwinds," he says.

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