Sometimes, fear pays off
NEW YORK – Bond funds enjoyed a surprisingly strong run this summer, but analysts say their advance had more to do with fear than fundamentals, as weaker-than-expected economic data and terror concerns made investors uneasy about equities.
Earlier this year, as the Federal Reserve began raising the federal funds rate off a 45-year low, many on Wall Street were predicting steep declines in the price of bonds, which fall as their yields rise.
However, despite the steady upward march of short-term rates – another quarter-point hike is expected next week, bringing the rate banks charge each other on overnight loans to 1.75 percent – domestic fixed income funds are up so far this quarter. According to fund tracker Lipper Inc., they’ve risen an average of 2.77 percent since the end of June. U.S. Treasury and high-yield funds posted above-average returns, while mortgage funds were at the lower end of the spectrum.
Better than half those gains came in August, when anxiety about soaring oil prices and potential attacks on the Olympics and the political conventions was at its peak, prompting a flight to safety among investors. Now that some of those fears have subsided, or been factored into trading, bond prices are likely to resume their decline.
“The reason bonds have done well this quarter … the actual technical term is ‘risk aversion,’ ” said Andrew Clark, a senior research analyst with Lipper. “When people are feeling fairly conservative, and risk aversion is high, that’s often good news for bonds.”
Investors who looked past the shower of gloomy forecasts earlier this year and held onto bonds have some reason to gloat. Active investors might even consider booking some of the recent gains. After all, bonds peaked last year and are unlikely to rally further, and most analysts believe they’re richly valued now and rising rates are bound to send prices lower eventually.
But from a financial planning perspective, it would be a mistake to sell all of your bond funds. While it’s easy to get sidetracked by returns, wise investors know that the point of holding bonds isn’t so much to profit as it is to balance risk.
“A few months ago, everybody ‘knew’ rates were going up and the bond market was going to do terribly, and that didn’t happen,” said Michael W. Boone, a financial planner in Bellevue, Wash. “That’s usually the way markets work. When everyone is betting one way, things don’t go that way. What bonds are going to trade on, more than what everyone knows about, is those unexpected events that everybody doesn’t know about.”
Whenever something shocks the market, Boone said, U.S. government bills, notes and bonds invariably rise in value, as investors rush for the highest level of security they can find. After Sept. 11, 2001, investors all over the world bought Treasuries because of the perceived safety of U.S. government paper – even though the terrorist attacks occurred on U.S. soil. Bonds, especially Treasuries, “can be a life preserver for portfolios when people are on the verge of drowning,” Boone said.
For most investors, it makes sense to keep at least 10 to 20 percent of your investment portfolio in fixed-income securities, no matter what’s happening in the market. But that doesn’t mean you should set it and forget it: There are ways to position your holdings to your best advantage.