Q&A: What to expect from your bond fund

By Stan Choe

AP Business Writer

NEW YORK (AP) - How many more times can bond funds ride to the rescue when stocks go on another one of their tumbles?

Markets are calm now, but it was only a month ago that a freak-out about the United Kingdom's departure from the European Union sent the largest stock fund to a two-day loss of nearly 6 percent. Through the turbulence, bond funds once again acted as investors' comforter and delivered steady gains. The Fidelity Total Bond fund, for example, rose modestly each of those days, returning 0.5 percent.

But the very success for bond funds means investors need to expect less from them going forward. Bond yields are low, with the 10-year Treasury note's below 1.60 percent. Low yields mean bonds not only produce less income but also have less room to rise in price. That's because they rise when yields fall. Their prices also fall when interest rates rise.

Ford O'Neil, portfolio manager at the $24.4 billion Fidelity Total Bond fund, recently talked about how bond funds can still be stabilizers for portfolios when stocks are shaky, but investors need to lower their expectations. Answers have been edited for length and clarity.

Q: Your fund has returned about 7 percent in 2016. Can it keep having these kinds of returns?

A: We are telling our clients two things. One: anticipate more modest returns going forward. With the Barclays Aggregate (index of high-quality U.S. bonds) yielding just below 2 percent, that's not a bad perspective on what to expect for returns. You also have to assume more modest equity returns as well.

And I think you have to expect a little more volatility as well. The U.S. economy and the U.S. central bank are diverging from what's happening in Japan and Europe. With that, you have to anticipate a more volatile environment.

Q: When you're saying more volatility, do you mean a bumpier stock market or a bumpier bond market?

A: It will be a combination. You will get volatility in both stocks and bonds. The Federal Reserve has dampened a lot of that volatility over the past eight years. I think they'll be doing less of that going forward.

Over the past eight years, we've probably had three quarters of the typical volatility for the bond market. I don't want people getting comfortable thinking the volatility of fixed-income investments has dropped for good. It's been driven by temporary, but long-lasting, Fed policies.

Q: So, lower returns for bond funds and higher volatility. Sounds like everything's working against bond funds. Why keep one?

A: All true, but a bond fund should still give you comfort when your equity portfolio is not faring particularly well. It will help dampen the volatility of your overall portfolio.

It's hard to step on my soapbox and tell everyone now's the time to rush to bond funds. But the alternative is cash, which is earning next to nothing and doesn't give you any upside when the equity markets are challenged.

Q: Your fund can go up to 20 percent in high-yield bonds, which are the ones most likely to default. You're close to that cap. Why so invested when default rates are at their highest level in years?

A: It's not because I think high-yield has never been cheaper. More importantly, I think Treasurys have never been less attractive.

We have had very, very low default rates, and they have been rising, although most of the increase has been in the commodity sectors. If you were to come to Fidelity and spend time with our high-yield group, you'd be amazed with how many analysts we have. If they are able to get the security selection right, the hope is that we're able to avoid many, if not all, of the defaults.

Q: For several years, critics were saying rising rates would mean big losses for bond mutual funds. When's the last time you heard the phrase "bond bubble?"

A: We heard it a lot in 2012. I hear it still fairly frequently.

If you look back at bubbles over the years - you can go back to the tulip bubble, the Internet bubble, the housing bubble - in all those cases, people lost 50 to 75 percent of their principal. If you're buying bonds, you should get your money back. They do mature at par, especially if they're government securities.

Where you have the greatest risk is if you have inflation - and not a rise from 1 to 2 percent but from 1 to 4 or 5 percent. The only way you can see a bond bubble is if hyper-inflationary forces come back to the United States, and I don't think there are a lot of people that feel strongly that's the case.

Q: A couple years ago, you said it would take a lot longer for interest rates to get back to normal than people were expecting. Now that yields are close to record lows again, would you say the same thing?

A: I would not. From an economic standpoint, the U.S. is OK. We're muddling along. The economy is not growing at gangbusters rates, but 2 percent growth (after inflation) is not bad. The glass seems a little more half-full, and I think bond yields fundamentally should be higher than where they are today.

Published: Wed, Jul 27, 2016