What Goes Up…

According to research firm Strategic Insight, bond mutual funds and exchange traded funds are expected to take in $300 billion in inflows this year, outpacing both 2010 and 2011.  Since 2009, investors have moved more than $1 trillion into bond funds which doubled total assets in that broad category.

This trend is causing concern for more than a few bond experts.  Michael Gitlin, director of fixed income at T. Rowe Price, recently stated, “Fixed income is more risky than at any time in the last few years.”

Ronald Schwartz, manager of the $1.1 billion Ridgewater Investment Grade Tax-Exempt Bond Fund, expressed a similar sentiment, “We’ve seen people reaching for yield and not being adequately compensated for the risk they are taking.”

Gus Sauter, chief investment officer at Vanguard, has been especially vocal about warning his investors.  This cautionary message was posted to the Vanguard website earlier this year:

“I’m increasingly worried that people aren’t aware of the risks in the bond market. The problem is that when you’re at historically low rates, as we are now … yields aren’t likely to go significantly lower, and at some point when the economy does strengthen, they’re likely to push higher.  If rates move sharply, we could experience a year or more where investors receive a meaningfully negative total return from bonds.  That’s certainly happened in the past.  And it’s very possible, if not probable, at some point in the future.”

When interest rates fall, bond prices rise.  That’s bond theory at its most basic level.  This simple fact has allowed long-term bond investors to capture equity-like returns over the last three decades.  Remember when the rate on your mortgage was double-digits?  While there have certainly been some periods of extreme volatility in the aggregate bond market over those years, for the most part, bond investors have enjoyed high single-digit (and even double-digit) returns with significantly less price volatility than equity investors.  This has lulled many into a false sense of security.

In 1981, the Fed Funds rate hit a peak of 16.39%.  Today it is near zero.  From 1981 through 2011, the average annualized return of an intermediate bond fund was 8.14% (Morningstar).  While there is no guarantee that rates will rise in the near future, it is mathematically impossible to receive a high single-digit average annual return from bonds over the next ten years, assuming you buy a long-term bond today.

Don’t get me wrong.  Bonds still deserve a spot in your portfolio, but as a risk-reducer and source of liquidity, not a return-enhancer.  Therefore, focus the majority of your bond allocation on short-term bonds.  They will suffer the least if and when interest rates eventually rise.  And don’t be afraid of stocks just because the economic outlook doesn’t seem real encouraging right now.

Back to Gus Sauter:

“A lot of people assume that stock market returns are driven by a country’s economic growth, but that’s really not the case.  A better predictor of future returns is valuation.  One measure of valuation is the price/earnings ratio (P/E ratio) and right now the market P/E is about 13x estimated forward 12-month earnings.  That is below the historical average of 15x and suggests that stocks are capable of offering a decent return to investors over the next 10 years.  I like the fact that many, if not most, investors are worried about stocks right now.  When people throw caution to the wind is when I start to get worried.”

There is a temptation in all of us to think about the future and try to prognosticate.  At Bell Wealth Management, we believe it is more important to focus on personal goals and ask these two questions, “What am I saving for?  What is the best approach to achieve my goals without taking undue risk?”  Once those questions have been answered, we begin the task of implementation focusing on broad diversification and minimizing investment costs, transaction costs, and tax costs.  It’s not what you earn that’s important, it’s what you keep.