April 4, 2013

Don’t Panic-Sell Your Bonds Just Yet: Vanguard Talks Investors Off the Ledge

‘A rising rate environment is not a bad thing for people who are in it for income,’ says Vanguard CEO Bill McNabb

With many investors seemingly on the precipice of selling all of the bonds out of their portfolios, the fixed-income experts have stepped in with some sensible talk to coax panicky investors off the ledge.

The experts’ challenge is to convince investors that while bonds’ strong returns of recent years won’t remain, they needn’t fear a complete selloff in the fixed-income markets. True, Federal Reserve policy and bonds’ strength have driven yields to historical lows—to near-zero territory for Treasuries, in fact. But there’s still plenty of bond-buying opportunity, the experts say.

“If interest rates rise, we'll see a decline in bond prices but, over the long term, a rising rate environment is not a bad thing for people who are in it for income,” says Vanguard Chairman and CEO Bill McNabb in a market comment on the Vanguard Group’s website. “If you're reinvesting part of the dividend, you'll reinvest at a higher rate, and that will compound over time.”

McNabb acknowledges that the next 10 years of bond returns won’t be what the past 10 have been, when the broad bond market returned about 5% a year: “It's almost mathematically impossible because yields currently are so low,” he says.

Yet bonds play an important role in a portfolio because they offer diversification, McNabb noted—with the proviso that yields are headed to a lower range. “Logically, with yields near historical lows, investors should have much more modest expectations for bond returns. I'm not saying to investors that they should abandon a sensible allocation to bonds. I'm just trying to help set realistic expectations.”

Similarly, Russel Kinnel, Morningstar’s director of mutual fund research, does his part to reassure bond investors, questioning the existence of the much-discussed “great rotation” in an analyst’s note.

Kinnel writes that the historic inflows to exchange-traded funds and mutual funds—$115 billion in inflows to ETFs and open-end mutual funds in January alone—are decidedly not hurting the bond markets.

“Some called this the great rotation, but it really looks more like a great influx,” Kinnel writes. “Investors aren’t selling bond funds to buy stock funds. Far from it. Intermediate bond funds remain the most popular open-end category with $11 billion in inflows. U.S. equities remain toward the back of the long-term asset-class pack; however, they did receive $15.5 billion in inflows—their best month since February 2004.”

So where should bond market investors look for the best fixed-income opportunities right now? In short-term securities, says independent investment advisory firm Gerstein Fisher, based in New York City, in its latest Research & Insights piece, “Long Rate Cycles and Your Bond Portfolio.”

“Many market participants wonder if a long cycle of declining interest rates is coming to an end,” Gerstein Fisher says. “Looking back over history reveals that allocation to short-term fixed income benefits portfolios during rising rate environments. Shorter-term bonds also fare well on a risk-adjusted basis in periods of falling rates.”

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Read how BlackRock investment strategist Russ Koesterich also questions the “great rotation” in Market Drives Record Fund Flows, Higher Returns in Q1 at AdvisorOne.

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