Investors could count on steady interest payments. Their funds also benefited from rising bond prices, because interest rates made a three-decade-long march downward since 1981. When yields fell, bond prices rose: Each step lower made the bonds held by mutual funds more attractive because they offered higher rates than newly issued bonds.
But the tide has shifted. Many analysts say we have hit a bottom for interest rates, and the yield on the 10-year Treasury note has climbed to 2.5 percent from 1.6 percent at the start of May
The rise in rates has led to losses for many bond mutual funds, and it's something that investors need to get used to, says Rick Rieder. He is chief investment officer of fundamental fixed income portfolios at BlackRock, the world's largest asset manager. He oversees $650 billion in assets, including BlackRock's Strategic Income Opportunities mutual fund (BASIX), which can own everything from long-term Treasurys to short-term corporate bonds to debt from emerging markets.
Q: What's a fair return that investors can expect from their primary bond mutual funds? Is not losing money too much to ask?
A: For the last 25 or 30 years, people have counted on bonds to provide their interest payments, plus a little bit of price appreciation. People have been investing with that expectation, and if you were just patient, your bond portfolio would work for you. The world has changed. The last couple of months were illustrative of how much the world has changed. It didn't take a big move in interest rates to send long-dated Treasurys down 12 percent over a two-month period.
It became evident, quickly, that returns in bond funds are going to be more volatile, even high-quality bonds. Over the coming couple of years, people should count on hopefully the coupon return, which in today's environment is a little over 2 percent, with a potential for it being in a moderately rising rate environment, which could mean zero or slightly negative returns.
Q: What's the worst-case scenario for bond funds? Could it be as bad as 2008 was for stock mutual funds, when the financial crisis meant the Standard & Poor's 500 index lost 37 percent?
A: I don't think you're going to see a crisis in bonds. Interest rates are not going to move up dramatically: We are in a low-inflation environment, global economic growth is slow, monetary policy is still very easy. I think what you'll see is an environment of gradually increasing rates, but that will lead to negative returns for a core, passive bond fund. Think of this year, where the average bond fund has had a 4 percent loss. That's a pretty big move.
Q: Does that mean that buying and holding a bond mutual fund is a bad idea now?
A: I think people are diversifying now to bond funds that can be flexible and tactical, which try to keep their sensitivity to interest rates down. They're not relying so much on government bonds. They're also investing in European bonds, at times, when valuations make sense. I think we live in a world where the way to make money in fixed income is to be flexible.
Q: Long-term bond mutual funds get hurt the most by rises in interest rates, because their holdings are locked into the lower rates for a longer period. Does it make sense for anyone to own a long-term bond fund today?
A: People should still own long-dated bonds, and core bond funds still make sense within a diversified portfolio. People haven't diversified as much over the prior few years as they should have, because they haven't had to. Not only have rates been trending down with slower growth, but you've had the Federal Reserve continue to push rates lower.
I don't say that you should sell all of your long-term bonds, but people should diversify to have less interest-rate sensitivity in their portfolio.
Q: How much more will the yield on the 10-year Treasury rise if the Federal Reserve slows its bond-buying stimulus program later this year, as many economists expect?
A: We think fair value on the 10-year is about 3 percent. So at today's levels, you've already eliminated two thirds of the distortion created by quantitative easing. As the Fed starts reducing, as you get into the beginning of next year, it could be in the low 3s.
For a more significant move, we would have to see a significant increase in inflation and the assumption that unemployment was improving dramatically, so that the Fed would have to move the federal funds rate. I don't think either of those is at our doorstep.
Q: Are there any widespread mistakes you see individual investors making?
A: People are very slow to recognize how different the world is going to be going forward. I think people underestimate that fixed income could be more volatile than the equity market, and historically we have never seen anything like that. I am surprised that people are still very comfortable with their traditional long-dated bonds.