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Bond Squad
The erratic effect of interest rates on bonds
Bond funds have weathered one storm, but more clouds could be building.
By Scott Berry, Morningstar
If there was one thing that investors could agree upon heading into 2004, it was that interest rates would finally move higher and that bond prices would finally move lower. Investors were warned here and elsewhere that bond funds could suffer as the economy improved and that rate-sensitive, long-term government bonds were likely to be at greatest risk.
It took a few months, but market yields did move higher in late March and April. The entire bond market slumped, while long-term Treasuries suffered through a particularly brutal stretch. However, with the exception of emerging markets, every taxable-bond category has posted a gain for the year to date through July 16, with the long-term government category climbing 2% and outperforming all other investment grade bond classifications. That's right -- the most rate-sensitive category of all has topped the charts since the beginning of the year.
Expectations drive the market
So what's keeping bond prices up and yields down? Expectations. When the bond market began to price in expectations for higher interest rates early in the year, the fear was that the Federal Reserves Open Market Committee would raise rates by 0.5% at either their June or August meetings. The Fed bumped rates just 0.25% at its June meeting and fears of a 0.50% hike in August have cooled, as a weak jobs report in early July and few signs of rampant inflation have most market participants expecting smaller or fewer rate hikes going forward.
The expectation for higher rates is still there though, at least according to many of the bond-fund managers that we speak with. Bob Rodriguez of FPA New Income (FPNIX) is so convinced that rates will move higher that he recently held more than 40% of the fund's assets in cash. Meanwhile municipal-bond managers at T. Rowe Price and Putnam have stayed defensive on rates by keeping duration (a measure of interest-rate sensitivity) relatively short.
Will the cycle repeat?
It's possible the economy could slow, jobs could dry up, and inflation could be muted. However, the economy appears to be on firmer footing now than it was six months ago. And with the 10-year Treasury yield at basically the same level it started the year (4.59% as of Thursday compared with 4.25% on Dec. 31), the bond market doesn't seem to offer a lot of upside potential. In fact, the market could be at a point similar to where it was in early March of this year, when a weak employment report buoyed bond prices. A month later jobless claims dropped, sending bond prices into a tailspin. Should an equally strong economic report come out within the coming weeks or months, we could see bond prices again move lower.
If there's one thing the first half of 2004 proved, it's that the bond market is not as predictable as many market participants might have thought or hoped. It's likely been a somewhat disappointing year for bond-fund investors that enjoyed heady returns during the market's extended rally, but compared to 1994 and 1999, when rising rates soaked a number of bond funds with big losses, it hasn't been that bad a year. Of course, the year isn't over yet.
Copyright 2004. Morningstar, Inc. All rights reserved.
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