The U.S. bond market is on track to suffer its worst year since 1981, but don't go overboard in dumping bonds, experts say.
Even though the economy is growing at a snail's pace, the Federal Reserve has telegraphed it is ready to begin rolling back its unprecedented stimulus as early as September.
The signal for this shift has rocked financial markets worldwide and in just a few months pushed interest rates to their highest levels in two years. Investors have run screaming from bonds, with more than $100 billion pulled from bond mutual funds and exchange-traded funds since the selloff began, according to TrimTabs.
But the World War II-era advice, keep calm and carry on, applies here. The government bond market has been a mess in 2013, for sure. Still, experts say it's a mistake to wipe out bonds from your holdings, because stocks might turn more volatile, and bonds, particularly higher-yielding corporate debt, could still provide decent income.
"It's possible for bond funds to turn flat to possibly earn slight positive returns at the end of the year," said James Sarni, managing principal at Payden & Rygel in Los Angeles which oversees $80 billion in assets. "Some of them have come back."
Within corporate bonds, the advice is to stick with those with shorter maturities. Investors will earn higher income than Treasurys because they carry higher coupon rates, and shorter-term issues are less vulnerable than longer-dated ones if the bond market sells off further.
They also recommend buying floating-rate debt whose interest payments reset as rates go up.
On the "avoid" list: municipal bonds and Treasury Inflation Protected Securities, as their average maturity tends to be longer, making them prone to heavier losses if yields spike again.
"If this market corrects again, it could adjust very violently," said Richard Schlanger, portfolio manager at Pioneer Investments USA in Boston.
If you have the stomach for risk, consider junk or high-yield bonds. This has been the best-performing U.S. bond sector so far this year, earning a 2.41 percent total return, according to Barclays. This compares with an 8.38 percent drop on Barclays' TIPS index and a 4.91 percent fall in its municipal bond index.
"Diversify out. A move to high-yield exposure is critical," said Kristina Hooper, head of investment and client strategies at Allianz Global Investors in New York.
The rocky road for long-dated U.S. bonds, especially Treasurys, will likely persist through the rest of the year as traders speculate on the timing for the Fed to stop buying Treasurys and mortgage-backed securities, currently at $85 billion a month, and eventually raise interest rates, though that is still not expected until early 2015.
Longer-dated Treasurys were on track for their worst four-month stretch since 1996 with benchmark 10-year yields rising more than 1.20 percentage points since May.
Barclays' index for Treasurys that mature in 20 years or longer has fallen 13 percent so far this year, which was on track for its worst year since it was launched in 1976.
DON'T COUNT BONDS OUT YET
In spite of their dismal performance, don't rule out a rebound for bonds in the fourth quarter, some fund managers say.
With global economic growth expected to creep along and stock markets unlikely to rise much further, yields should at least hold at their current levels. This would allow corporate bonds, mortgage-backed securities and other higher-yielding debt to generate enough income to make up for the steep price drop they suffered.
PIMCO's Bill Gross, who runs the world's biggest bond fund, sounded defiant in his August investment newsletter in which he wrote: "Stick with PIMCO, we're going to win this new war!" His $268 billion PIMCO Total Return Fund is on track to post its first annual loss in at least a decade.
While junk bonds have clung to modest gains, the rest of the bond market has been stuck in the red since late May, when it fell into negative territory following remarks from Fed Chairman Ben Bernanke that the central bank might scale back its monthly bond purchases if the economy improves further.
The U.S. economy expanded at a 1.7 percent annualized pace in the second quarter, far below the 2.5-3 percent average range that accompanies sturdy job gains and consumer spending.
"The growth we are seeing is not strong growth," Sarni said.
TOUGH ROAD AHEAD
If benchmark U.S. yields fall by 0.5 percentage point between now and year-end, most benchmark U.S. bond indexes have a shot to eke out gains for the year.
"You need yields to fall to break-even. Coupon income alone won't make up for the price drop," said Jeff Rosenberg, chief market strategist for fixed income at BlackRock in New York.
That outcome, however, looks less likely unless the economy falls apart and/or the Fed drops its expected plan to shrink its bond purchases, analysts and fund managers said.
"It's unlikely the market will rally by the end of the year, but we are not expecting any significant rise in rates either," said Dan Dektar, chief investment officer at Smith Breeden Associates in Chapel Hill, North Carolina.
At these levels, the market offers some relative bargains, but Dektar cautioned against jumping back on the bond bandwagon.
"If you are underweight now, you should reduce your underweight. If you are overweight, I would not be significantly overweight," he said.
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