Fund manager Q&A: Expect less from bonds

By Stan Choe

AP Business Writer

NEW YORK (AP) -- Bonds aren't doomed.

They lost money last year and still face challenges, but you can still profit from bonds--just not as much as in the past. So says Ford O'Neil, the lead manager of Fidelity's $13 billion Total Bond fund (FTBFX), whose returns have topped 80 percent of its peers over the last 10 years.

Bonds are supposed to be the safe part of a portfolio, but the Barclays US Aggregate Bond index lost 2 percent last year. Many funds use the index as their benchmark, and it was the index's largest loss since 1994. Rising interest rates knocked down the price of existing bonds last year, and strategists expect rates to move higher as the economy recovers. O'Neil talked about what bond-fund investors can expect.

Q: How fast will rates rise? The yield on the 10-year Treasury is below 2.7 percent.

A: Our feeling is that normalization will take much longer than people expect. That was our view in 2009, when everyone was saying rates would go up a lot, and we've said it for five years in a row because the economy is far more fragile than in prior recoveries.

Q: And normalization means?

A: Normalization means bonds have historically had real rates of 1 to 2 percent and inflation has run between 1.5 and 3 percent ... so the 10-year Treasury at, say, 3 to 4 percent. We think it's a long run to get to the upper end of that range.

We're not expecting economic growth to be 3.5 to 4 percent, the way everyone's grown accustomed to it bouncing back following recessions. We think the economy continues to muddle along for the next two to four years--not great growth, not bad growth, just kind of 1.5 to 3 percent.

Q: What about inflation, which hurts bond investors?

A: It's going to remain relatively benign for the near future, 1.5 to 2 percent. A lot of that is driven by wages, and wages remain quite stagnant. Of all the companies coming through Fidelity, we don't see any of them pounding the tables saying, "We can't find workers and need to pay everyone a lot more."

Q: Low inflation, a muddling-along economy and a slow rise in interest rates makes it sound like you can still make money with bonds.

A: You can. If you look at the history of bond returns, over the last 60 years, you had negative returns in less than half a dozen years. It's just the nature of the way bonds work. You have that nice income cushion that helps you when you have a rising-rate environment.

Q: But have we ever started from a place where rates were as low as now?

A: We did. If you go back to the 1940s, coming out of World War II, the Fed was suppressing interest rates. The government had massive amounts of debt, and we had just come out of a terrible economic period--kind of like today. It wasn't until the early '50s when the Fed finally decided the economy could stand on its own. At that point the 10-year Treasury went from 2 and an eighth to 15 percent in the early '80s. Your worst return was when you lost 3 percent. That's because as rates rose, you were getting more and more income each year, so you can withstand jumps in rates.

Q: So what's fair to expect from bonds now?

A: This is one of the things we're spending a lot of time on with clients, getting them to have more modest expectations. From '82 to '13, for 30 years, they were getting 5 to 8 percent a year. It was a fabulous bond market rally. We're telling them 2 to 4 percent is a much more reasonable expectation.

Q: You can invest as much as 20 percent of the Total Bond fund in high-yield junk bonds. Are you close to that now?

A: The last published numbers show 10 percent in high yield, 2 percent in emerging markets that are not investment grade and 2 percent in high-yield commercial mortgage-backed securities.

Q: What if someone just wants a vanilla bond fund, something to provide ballast for their portfolio?

A: There are a lot of clients that want to own bond funds that own nothing but U.S. government-guaranteed securities, and we provide that for them. But they have a lot less flexibility. A good example is last May and June, when all of our funds did poorly. As a manager of Total Bond fund, I could go and add to the sectors that were doing by far the worst to try to make up for some of the underperformance due to the increase in rates. A lot of these other managers are constrained to their own universe, even if other sectors are cheaper than theirs.

Published: Wed, Apr 16, 2014