Fixed Income May Surprise
When a bond manager tells you things are boring, you know they're boring. And 2006 was a pretty boring year for fixed-income investments, especially U.S. government bonds. "Right now we are in a low-volatility environment," says Robert Auwaerter, head of fixed-income portfolio management at Vanguard, "not only in terms of overall movement of interest rates but also the spreads between non-treasury and treasury securities."
Indeed, according to statistics from the Chicago Board of Trade, volatility in the 30-year U.S. treasury bond was as low last year as it has been since 1997. And the difference in yields between riskier paper such as emerging-market and high-yield bonds versus similar-maturity U.S. treasuries was only a scant 1.75 and 2.75 percentage points, respectively, at year end, notes Mary Ellen Stanek, head of fixed-income strategy at Baird Advisors. "There's a lot of money sloshing around the world in search of returns, and that has compressed spreads," she explains.
Upside down. Then there is the much-noted inverted yield curve, where short-term interest rates are higher than long rates. At the start of this year, the yield on the three-month treasury was 5.06 percent while the yield on the 30-year bond was 4.8 percent, despite the long bond being an inherently riskier investment. So between cash-rich hedge funds and a strong global economy, investors aren't being paid a premium for taking on risk. And with narrow price swings can come boring returns. The Lipper General U.S. Treasury fund index gained just 3.4 percent last year. "That's mediocre," Auwaerter says. The Vanguard Long-Term Treasury fund was up only 1.74 percent (vs. a five-year average of 6.84 percent). With inflation running about 2 percent a year, government-bond investors were treading water.
But investors might see fatter returns in 2007, in the view of many bond market analysts-along with more volatility. "It's going to be a good news/bad news story," says Jim Sarni, senior portfolio manager at Payden & Rygel. "We will have a slower economy, and that is good news for bonds." At the very least, it will probably spell an end to the yield-curve inversion. If the Fed lowers short-term rates by at least a quarter percentage point in 2007, bond prices will rise.
But like most economists, most bond fund managers are looking for a soft landing, meaning no recession. "High-yield [corporate] bonds should also do well next year because of the soft landing," says Nasri Toutoungi, a fixed-income portfolio manager at Hartford Investment Management.
Auwaerter is wary of high-yield bonds. Not only have they put in a stellar performance in recent years-and therefore are due for a correction-but many of them have been used in buyout deals. A slower economy could make all that buyout debt tougher to manage. "If the economy's fundamentals can't support them, you could get rising defaults," he warns.
This story appears in the January 15, 2007 print edition of U.S. News & World Report.