Economic worries last year turned out to be great news for bond investors.
Interest rates fell sharply and bond prices rose as recession fears grew through the summer, resulting in the most profitable calendar year for bond fund investors since 2002. Core investments such as the Vanguard Total Bond Market Index mutual fund and the iShares Core U.S. Aggregate Bond exchange-traded fund gained nearly 9% in 2019.
Investors playing it safe in high-quality short-term bonds profited, too. The 3.5% gain for the Schwab Short-Term U.S. Treasury ETF was more than a percentage point above inflation. The Baird Short-Term Bond fund gained 4.7%.
But the bond party of 2019 is expected to give way to a bit of a hangover this year.
“You don’t get those kinds of returns two years in a row unless something really bad happens to the economy and interest rates take another slice down,” said John Mousseau, director of fixed income at Cumberland Advisors, a money manager.
That’s not widely anticipated. Mike Pyle, global chief investment strategist at BlackRock, expects that “the big forces” that set off last year’s bond rally are “going to recede into the background.”
After three rate reductions last year in response to concerns about global growth, the Federal Reserve is now signaling that it intends to sit tight this year as improving economic data has apparently reduced the likelihood of a recession. “The barriers to cutting rates seem pretty high, and the barriers to raising rates from here are higher still,” Pyle said.
A better global economic outlook should also tamp down demand for U.S. bonds. Last year, when global recession chatter was increasing during the U.S.-China trade war, investors clamored for the safety of U.S. Treasuries, which had the added allure of offering much higher yields than the negative rates paid on government bonds issued by Japan and many European economies.
The yield on the 10-year Treasury note fell from a high of 3.25% in late 2018 to a low of 1.45% in early September. That yield tumble — which played out in corporate and municipal bonds as well — is what set off the big 2019 gains for bond funds and ETFs.
Mousseau expects that the 10-year Treasury could rise from its current 1.9% to 2.25% this year. “We are back to clipping coupons,” he said. Without falling rates to increase prices — interest rates and bond prices move in opposite directions — returns will be a simple function of the interest bonds pay. That suggests core bond returns of around 2%.
While bond investors profited as rates fell, the Fed’s 2019 U-turn was “a big disappointment” for money-market investors, said Ken Tumin, editor of DepositAccounts.com.
After seeing cash rates rise throughout 2017 and 2018 — the first signs of life since the financial crisis for savers seeking safe and liquid income — rates slumped in 2019 in sync with the Fed’s rate cuts. For example, in December 2018, the online Ally bank offered a certificate of deposit that guaranteed a 3.1 annual yield for five years, which was well above the rate of inflation. A five-year Ally C.D. bought in December paid a 2.15% yield.
Tumin said high-yield savings accounts from online banks and credit unions offer the “most bang for the buck” for savers today. While brick and mortar banks and credit union savings accounts pay less than 0.2% on average, there are plenty of online savings accounts with yields ranging from 1.7% to above 2%.
Despite that risk-free opportunity to bolster cash performance, Christopher Cordaro, chief investment officer of RegentAtlantic financial advisers, said he sees plenty of new clients who are “earning next to nothing at their brick and mortar.”
He said he has taken on clients who had more than $1 million in an old-school bank account with virtually no yield. That inertia works out to a self-imposed penalty of $17,000 to $20,000, which is about what $1 million can earn if it is moved to a high-yield savings account.
Cordaro also said savers are probably leaving cash on the table in their brokerage accounts. “Brokerage firms have gone to charging zero commission on trades, but they can afford to do that by basically paying nothing on your sweep account,” said Cordaro, referring to the cash account where proceeds from trades are parked.
According to Crane Money Fund Intelligence, the average brokerage sweep account had a yield of 0.13% in December. Money-market mutual funds offered by those same brokerage firms — but not the default option — paid more than 1%.
For example, making a low-yielding bank account the default option for cash accounts has become a major revenue generator for Schwab. A $100,000 balance in a Schwab sweep account had a 0.06% yield in December. Alert investors who move their cash into a Schwab money-market account could earn more than 1.5% in December.
“‘Free’ makes people do silly things,” Cordaro said. “You would be better off paying $5 to trade and have a better sweep account.” Fidelity and Vanguard continue to use money-market mutual funds, with higher yields than bank accounts, as the default for their investors.
For longer-term bonds, investors may need to accept that they need to emphasize either safety or income. But no single type of bond is likely to excel at both.
While Treasury yields are meager, Treasury bonds are the best ballast when stocks are falling, and that is worth remembering more than 10 years after the start of a stock bull market.
Pyle, of BlackRock, noted that with low concern for a sharp pickup in inflation, prices for Treasury Inflation Protected Securities have not been bid up as much as those for regular Treasuries. That makes 2020 a “good entry point” to build in some long-term protection to rising prices. Morningstar, the fund research firm, recommends Vanguard Short-Term Inflation-Protected Securities and Schwab U.S. TIPS.
For income seekers willing to take on more risk, Pyle said, high-yield bonds are a reasonable way to generate more income, if you accept BlackRock’s outlook for moderate growth, without a recession, in the United States this year.
For example, the Vanguard High-Yield Corporate fund had a yield of 4.2% in December, compared with 1.7% for the Vanguard Intermediate Treasury fund. BlackRock also recommends emerging-market bonds, which it says could do well at a time when the global economic outlook is solidifying. The TCW Emerging Markets Income fund has a 5% current yield.
But high yield is often called “junk,” because it comes with a risk. When stocks are falling, bonds that pay higher yields tend to experience sharp price declines that lead to negative total returns. During the last bear market, the Vanguard High-Yield Corporate fund lost 24%. TCW Emerging Markets Income lost 10%. Vanguard Intermediate Term Treasury delivered the ballast, gaining nearly 17%.