For the past two years, bonds have enticed investors by offering security and strong returns -- a far cry from the wild-eyed volatility and dismal performance of many stocks.
But this year, bonds will no longer be such a sure bet, experts say.
Bonds do best when both interest rates and inflation are falling. And those conditions, which have held true for the past year, might disappear in 2002. "Some of the really strong tail winds that have contributed to the bond rally over the last couple of years are probably in the past," says Alan Papier, a Morningstar analyst.
But most retail investors seem to think the tail winds are still strong. They have continued to pour money into bond funds. Through the end of November 2001, bond funds saw net inflows of $76.5 billion, compared with net
of $50 billion for the same period in 2000.
Bonds, of course, help to diversify and reduce risk in portfolios. "
But if you're a retail investor, you probably want to own less bonds going forward and more stocks," says Paul Lefurgey, manager of the
Phoenix-Duff&Phelps Core Bond fund.
Interest Rates: Headed Up?
One main reason to decrease the bond weighting in your portfolio is that interest rates most likely will begin to increase. At the beginning of 2001, the
federal funds rate stood at 6.5%. Successive rate cuts have chopped away 475 basis points to bring the rate to its current 1.75%.
"At this point, I think it's safe to say the
Fed for the most part is done lowering rates," says Papier. "The evidence is just that there aren't too many more bullets left in the gun because rates are already so low."
A rise in interest rates depletes the value of existing bonds. Suddenly, they become worth less than new issues offering higher interest rates, so their price drops.
But a rate hike might not come immediately. Typically, the Fed waits until an economic recovery is under way before raising rates, notes
Pimco bond guru Bill Gross. In a December commentary on the bond market, he wrote that after the last recession, it took a year and a half before the Fed began to tighten interest rates. Previous recessions in 1969-71, 1974, and 1979-81 produced no significant central bank hikes until an average of 12 months later.
"If interest rates stay within a fairly narrow band of where they are now, it would definitely be good for bond funds," says Morningstar's Papier.
But still others caution that investors should be prepared for a possible rise in rates. "We're not calling for substantial tightening in 2002, but we do believe the Fed will begin tightening," says bond fund manager Lefurgey. "And that should cause bonds to underperform stocks in 2002."
Inflation Could Be a Trouble Spot
An economic recovery might be accompanied by a rise in inflation, which would also hurt bonds. Inflation eats into the value of a bond's fixed payouts, making them worth less.
yield curve is extremely steep, that's an indicator that investors are worried about the specter of inflation creeping in," says Papier. "And we have seen a significant steepening of the yield curve throughout the year."
But some bond fund managers aren't too worried about any near-term resurgence of inflation. "Recessions, such as the one we've had for the past eight months or so, create a considerable amount of excess capacity, which over time produces lower inflation," wrote Pimco's Bill Gross. "It's a high probability that, with industrial operating capacity at 75% and unemployment accelerating up to and through 5.7%, inflation will not only come down, but also will stay down for all of 2002 and beyond.
"Even a V-shaped recovery, which we don't expect, would take several years to threaten a resurgence of inflation," he wrote. "In turn, gloomy global economies, especially that of Japan, promise no excessive demand pressures anytime soon."
Pockets of Strength in the Bond Market
Gross says fears of a bear market in bonds this year are exaggerated. Yet like other bond investors, he's repositioning his portfolio for an altered macroeconomic outlook. He's focusing on higher-yielding bonds that trade at significant spreads to
Treasuries, such as
mortgages and emerging-market debt.
Higher-yielding bonds are considered less interest rate sensitive than government securities. For example, corporate bonds benefit from an improving economy, which helps companies strengthen their balance sheets.
Lefurgey, too, says he's underweighted Treasuries and overweighted corporate issues. He's also adding to his mortgage weightings on the assumption that if interest rates rise in line with his expectations, fewer people will prepay their mortgages. "We suggest starting to increase risk exposure in corporate and lower-quality corporate, especially," he says. "We feel very comfortable with products that have extra yield and extra spread."