Mid-Year Outlook for Bonds

In my January outlook column, I said that bonds would lose 2% or so over the first part of 2018, even after accounting for interest payments. I regret to confirm that this forecast was on target, as Bloomberg Barclays U.S. Aggregate bond index is down 2.7% so far this year. As an ardent bond investor, I’d rather see positive total returns. But I still don’t believe it’s dangerous to own interest-paying securities, whether bonds or bondlike alternatives. Fixed-income investors will lose a little principal as interest rates rise (prices and rates move in opposite directions), but you’ll still get paid on time. Nonetheless, considering that no investment category can gain indefinitely—and that includes bonds, stocks, real estate, gold, oil and even rare wine—it’s time to ask whether bonds and bondlike investments have finally crossed a red line and are headed for deeper losses.

My judgment is that rates are range-bound—albeit at a higher range than before. So the rest of 2018 will be flattish, leaving fixed-income portfolios mildly in the red. Not deep red, but somewhere between peach and salmon. I’m figuring on some annoying but insignificant sell-offs that might shave 2% off returns for municipal bonds or nick investment-grade corporate bonds by 3%. But I also anticipate enough rallies and bounces that bond prices overall will be little changed from the time you read this. The value-hunters have already helped lift real estate investment trusts and utility stocks off recent lows.

Interest rates aren’t the only concern. The market will be buffeted by the complicated interactions of a number of factors, including Federal Reserve policy, oil prices’ impact on inflation, stock market instability, and the previously falling but now surging dollar's exchange rate. And there is the specter that a year or two from now, the Tax Cuts and Jobs Act will goose the deficit enough that the Treasury won’t be able to find takers for all the new bonds it will need to sell without a marked leap in the initial yield. In fact, an increased supply of all kinds of bonds could start to weigh on the market. In recent years, not only Treasuries but also municipals, floating-rate bank loans and other debt have been in short supply. But the shortages are gone, which means there is no longer a scarcity premium boosting prices.

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No Grizzly in Sight

There’s no sign of a brutal bear market. Bond prices will benefit from skittishness about the crazy ups and downs in stocks, says George Mateyo, chief investment officer of Key Private Bank. “Bonds are now more competitive with stocks” due to higher current yields and perceived safety, he says.

Dan Fuss, the Loomis Sayles Bond Fund manager and fixed-income savant, espouses a defensive strategy built around high-quality bonds and those with short durations. (Duration is a measure of interest-rate sensitivity; the shorter the duration, the less the implied loss as rates rise.)

I think some of the best choices now include floating-rate bank loan funds; two- to five-year Treasuries; short-term, investment-grade corporate bonds; high-yield bond mutual funds; and all municipals. Standout funds include Dodge & Cox Income (symbol DODIX), which invests primarily in high-quality bonds, and DoubleLine Total Return Bond (DLTNX), which invests in mortgage-backed securities (and is a member of the Kiplinger 25, the list of our favorite no-load funds). Or build a ladder of Treasuries that mature at staggered rates—say, one to seven years. If you find muni issues that pay upward of 3% for 10 or 20 years (munis come with longer terms because they finance durable projects, such as bridges), buy them, as the tax break is still valuable for most investors.