NEW YORK — It took less than six months for some of the most feared investments to get investors to reconsider.
At the start of this year, much of Wall Street expected trouble ahead for long-term bonds. The bond market had just posted its first losing year since 1999, a result of rising interest rates. The conventional wisdom was that rates would only climb higher, and long-term bonds would bear the brunt of the impact.
But the opposite happened. Rates have dropped since January, and long-term bond mutual funds have been some of the best performers. Funds that focus on U.S. government bonds with an average maturity of more than 10 years have recorded an average return of 11.2 percent. That’s the most among the 32 bond-fund categories that Morningstar tracks. Mutual funds that also own long-term corporate bonds have returned 6 percent. That’s just ahead of stocks in the Standard & Poor’s 500 index.
How’d they do it? Part of it was due to short-term factors. Tensions in Ukraine led to higher demand for safe investments like bonds, as did worries about a weak, polar-vortexed first quarter for the U.S. economy. But longer-term issues also were at play. Investors are debating whether the bond market is in a “new normal,” one where interest rates will remain lower than before due to weaker growth, says Bob Jolly, head of global macro strategy for fixed income at Schroders.
But first, a reminder on some of the mechanics of bond mutual fund returns. Bond issuers make regular payments to their bondholders. Bond prices can also rise and fall, which affects total returns. When interest rates rise and newly issued bonds begin to offer higher yields, the price of existing bonds drops because their yields have suddenly become less attractive.
That’s what happened last year. The yield on the 10-year Treasury note rose to nearly 3 percent from 1.76 percent in 2012. Long-term bonds are hurt more by a rise in rates because their yields are locked in for a longer time period. Investors yanked a net $1.8 billion from long-term corporate and government bond funds in the last three months of 2013.
But this year, the yield on the 10-year Treasury has dropped to 2.6 percent, and bond prices have rallied.