Last year many investors turned to U.S. Treasury and other government-backed, more conservative securities. If you were one of them, now may be a good time to reevaluate your investment strategy to make sure you have proper exposure to fixed-income securities beyond Treasuries and cash. Here’s why.
The key theme in last year’s fixed-income markets: the credit crisis, which drove increased demand for lower-risk investments.
If you fled to U.S. government bonds, you weren’t alone. As the crisis unfolded last fall, many investors sold securities that were, or were feared to be, losing value. Instead, they bought bonds with explicit government backing, including U.S. Treasuries and Ginnie Maes and other bonds from government-sponsored agencies like Fannie Mae
What’s happening now
Things have changed in 2009. Through May, an unprecedented amount of U.S. government and monetary policy actions has led to improving credit market conditions. Leading economic indicators have signaled a slowdown in the rate of economic decline, and in some cases show signs of improvement. Last fall’s performance trend has reversed, with positive year-to-date returns reflecting greater demand for fixed-income securities that are not backed by the U.S. government. Year-to-date total returns for high yield bonds (24.3%), leveraged loans (15.8%), and emerging-market debt (11.1%) demonstrated their rebound from major losses in 2008. At the same time, Treasury returns (-4.9%) and other government-backed securities (e.g., mortgage-backed securities) have underperformed, despite massive purchases of some of these bonds by the Federal Reserve. (See table below.)
At the end of May, the yields on Treasury bonds remain near historic lows, seeming to offer little room for growth when the market climate improves or interest rates rise. (One exception is Treasury Inflation-Protected Securities, or TIPs.) At the same time, the yields paid by non-government bonds—while lower than in February—are still much higher than normal, relative to risk-free Treasuries. This means that investors who can tolerate some volatility in returns may earn relatively higher yields while they wait for the economic climate and credit markets to improve. While the Fed’s recent purchases of Treasuries may continue to provide support for government-backed securities in the near term, if the economy improves and interest rates climb, the historically low current yields on these bonds offer little protection.
What it means for you
The past year has made it obvious that shifts in credit and interest rate expectations can influence the performance of the different types of bonds. Since the prices of certain bonds may move in different directions from other bonds as market conditions shift, Fidelity suggests that investors who own fixed-income investments consider diversifying. To help stabilize a fixed-income portfolio over the long term, consider bonds with different risk and return characteristics. While yields on many nongovernment bonds have come down from their recent peaks, in many cases they are still well above historical norms. If you can tolerate additional volatility in your portfolio, you can find some relatively high yields for a portion of your fixed-income investments while waiting for economic recovery. Given the ongoing uncertainty about current credit market conditions, now may be a good time for you to reevaluate and potentially rebalance your bond holdings.