Bonds: Strong in '09, Volatile in '10

Lipper's latest data show that most bond groups are in positive territory for the first month of 2010.

In the beginning few weeks of the year, through February 4, taxable Lipper Fixed Income Mutual Fund Indexes had results of up to 2.12 percent. This top performance was achieved by the Lipper Intermediate U.S. Government Index. The largest category tracked by Lipper, the Lipper Intermediate Investment Grade group with $253 billion in assets, rose 1.96 percent through early February. It is up 16.72 percent for the past 12 months. The Lipper High Income Current Yield Bond Index has risen by about 44 percent in the past year. Overall, the tax-exempt funds tracked by Lipper are up an average of 10.67 percent from February 2008 to February 2009. Research from the Financial Research Corporation shows that intermediate-term bonds amassed more than $129.4 billion in net inflows in 2009, including about $8 billion in December. The broader category of corporate bonds had $235 billion in net inflows in 2009, with $17 billion coming in during that last month of the year. The tax-free category had $88 billion of net inflows last year, while international/global fixed income drew $30 billion in assets. In its latest outlook report on fixed income, Schroder Investment Management North America says bond investors face a challenge this year. "While it's true that credit spreads are closer to their long-term averages and most fixed income relationships are on the road to normalizing, there remain very significant challenges ahead since many of the excesses and imbalances at the root of the 2008-2009 market gyrations have yet to be resolved," explains David Harris, senior portfolio manager. "Unlike 2008 and 2009, the key driver of performance in 2010 will be the higher return volatility between individual issuers and industries rather than between broad fixed income sectors," Harris says. This year, it's security and industry selection that will factor much more heavily into strategy as bond investors begin to more carefully distinguish between entities that have improved their competitive positioning and those no longer able to "kick their problems down the road." Schroders' four main themes are (1) U.S. economic growth, which will continue to benefit from the lagged effects of significant economic and monetary stimulus, but at a pace that's far below the strong growth typical of recovery periods; (2) debt reduction, which will remain a goal for most borrowers; (3) no stimulus exit strategy for now, as the Federal Reserve waits for declines in unemployment and spare capacity before raising rates; and (4) the prolonged zero interest rate policy, which continues to encourage risk taking from investors and hence inflows to higher yields. "Our themes for 2010 suggest that while corporate bonds will again outperform governments, owning the right credits will be more important than overall asset class exposure, making good security selection key to returns," shares Harris. The U.S. high yield bond market is likely to have another strong year of returns in 2010, after a record- shattering year in 2009, according to Wesley Sparks, a high yield portfolio manager with Schroders. In the first half of the year, high yield returns are likely to be strong as a result of continuing economic recovery and supportive central bank policy, Sparks says. "As volatility in both the equity and interest rate markets remains stable or declines further, investor risk appetite will improve. By the second half of the year, however, this near-perfect environment for the high yield market is likely to start evolving toward a world that is either too hot or too cold." Hence, he adds, investors should maintain market exposure in high yield in early 2010, but re-evaluate conditions as the year unfolds. "For 2010, we estimate that the total return of the high yield index will be in the low double-digit range, perhaps 12-13 percent, based on coupon income of approximately 8.7 percent plus approximately 4 percent capital appreciation generated by a further decline of 100 basis points in the yield on the index." For those who fear that profit taking in 2010 could lead to poor returns this year, Sparks notes, historical experience says otherwise: "In each case of the three previous strongest years for high yield returns (1985, 1991, and 2003), the total return for high yield bonds in the subsequent year was also strong, in the range of 10-20 percent." In terms of municipals, "Barring a completely bearish bond environment, investors should experience returns in line with the long-term average of 5.0 to 6.0 percent generated over the last 20 years according to the Barclay's Municipal Bond Index," explain Dan Scholl and Susan Beck, co-heads of Schroders' U.S. tax-exempt fixed income group.