What role should bond funds play in investors' portfolios today? That's essentially the question posed by Princeton University professor Burton Malkiel in a recent Wall Street Journal op-ed. And the answer has important implications for bond fund investors and managers alike.
Bonds have traditionally added ballast to portfolios, providing a dose of stability against more volatile stock market holdings. Happily, over the past three decades, they've actually done more than simply dampen risk. A 30-year period of falling interest rates has allowed bonds to provide returns that have been competitive with stocks.
But the era of near-double-digit returns from bonds is well past us, and in its place is a future in which bond funds look poised to provide rather humble returns going forward.
What's driving this, of course, is the low-interest-rate environment. As Malkiel points out, the current yield on a 10-year Treasury bond is about 2 percent, which is lower than the current inflation rate of 3.5 percent. And if inflation begins to tick up (as many have been anticipating for the past two years), bond investors will be looking at real (inflation-adjusted) returns that are significantly negative.
That scenario is why Malkiel suggests that investors might have to venture a bit farther afield in their search for income and diversification, offering up municipal bonds and dividend-rich blue-chip stocks as possible alternatives.
But if bond fund investors find themselves frustrated by the tough choices they're confronting, they might take a small measure of comfort from the knowledge that the picture isn't much brighter from the fund manager's seat.
Low interest rates have put a great deal of pressure on fund managers, who are facing significantly more scrutiny on the fees they charge and the value they add. Even worse, the evidence indicates that they're finding themselves on the wrong end of that analysis.
This year has been a particularly brutal one for bond fund managers, as the widely forecast "bubble" in Treasury bonds never popped. As a result, managers like PIMCO's Bill Gross ---- found themselves drastically underweight Treasury bonds as their popularity continued to soar.
Although it's true that 2011 is far from an anomaly -- a recent Bloomberg article noted that eight out of 10 bond fund managers have trailed their benchmarks over the past 20 years -- this year might represent a tipping point. In that same article, BlackRock's head of fixed income Peter Fisher said, "we're moving into the second phase of the index revolution," in which fixed income investors come to the same realization that equity fund investors did a decade or so ago.
The evidence indicates that Fisher is right. In the three years ended 2003, index funds accounted for just 8 percent of new cash flow into taxable bonds. In the most recent three-year period, that share has nearly tripled to 23 percent.
Is Fisher right? Are fixed income investors ready to throw in the towel in the search for outperformance in exchange for the low costs and relative predictability that index funds offer? In the face of the low yields and poor relative performance that today's fixed income investors face, there could hardly be a more rational response.
Ultimately, that's likely great news for bond fund investors; not so great news for bond fund managers.