Bonds share the pain
Interest rates fell sharply in 2008. The federal funds rate has dropped to 1% from 4.25% a year ago, and the prime rate has declined to 4%, from 7.25%.
While lower interest rates are good news for bond prices, only government bonds have rallied in 2008. Even the highest-rated corporate bonds have been hurt by credit concerns, and investors in high-yield corporate or municipal bonds or emerging-market debt have seen losses of more than 20%.
Some of the same factors that hurt stocks hurt bonds. To reduce leverage and meet client redemptions, many institutional investors were forced to dump all investments, including bonds. Wholesale selling of bonds can be especially tough on bond prices, since most areas of the bond market have limited liquidity.
Another factor weighing on bond prices is the inability of corporations to issue new debt. If companies can’t issue debt, they can’t roll over existing debt as it comes due. The inability to refinance debt heightens default risk and knocks down bond prices.
To be sure, the Fed’s attempts to thaw frozen debt markets via bailouts and debt-backstopping measures should have a positive effect on bonds in 2009. However, recession fears will keep default risk front and center with many bond investors, potentially hindering returns for high-yield and other speculative bonds.
Carnage in the bond market has lifted yields to some of the highest levels in years. The table below shows yields on a variety of government and corporate debt. Investment-grade and municipal bonds seem especially attractive.
In contrast, yields on Treasurys don’t look good. The rate on a 3-month T-bill is just 0.0%. The rate on a 10-year T-note is 2.7%, reflecting strong demand for Treasurys as a safe haven. While owning Treasurys paid off in 2008, similar returns seem unlikely in 2009. Over the long term, yields barely above zero provide little protection from inflation.
For investors wanting to capitalize on attractive yields without venturing too far out on the risk spectrum, Vanguard Short-Term Investment-Grade ($9.59; VFSTX), yielding 6%, and Vanguard Total Bond Market ($10; VBMFX), yielding nearly 5%, are solid choices. For exposure to tax-exempt municipal bonds, consider Vanguard Intermediate-Term Tax-Exempt ($12; VWITX), yielding 4.1% tax-free. Another attractive bond option is Vanguard GNMA ($10; VFIIX). The fund invests at least 80% of assets in Government National Mortgage Association certificates. Yielding 4.8%, Vanguard GNMA is one of few bond funds with a positive return (5.9%) in 2008.
For investors who prefer a balanced approach to income, the Forecasts recommends Vanguard Wellesley Income ($18; VWINX). The fund is approximately 60% bonds and 40% stocks. Vanguard Wellesley has an excellent track record and provides a solid choice for investors who want both bond and stock exposure in the same fund.