Despite outlook, stick with bonds, Vanguard says

The outlook for fixed income is about as grim as it has ever been, but that doesn't mean that investors should be thinking about heading to cash, according to The Vanguard Group Inc. Since interest rates spiked in May and again in June, investors have been doing just that. Assets in money market funds have grown by $64 billion since the beginning of May, when the 10-year Treasury was yielding 1.66%. It has since shot up to more than 2.5%, causing the Barclays U.S. Aggregate Bond Index, the benchmark of investment-grade credit, to fall by about 2.2% year-to-date. The volatility in the bond market has led to a bond sell-off, with $66 billion being pulled out of all bond funds since the beginning of May, according to the Investment Company Institute.

MISSING OUT

The problem is, though cash means principal protection, financial advisers would be missing out on yield while they waited to time their way back into the market. “The biggest challenge with moving to cash is, you're expecting to time interest rates better than everyone else out there,” said Chris Phillips, a senior investment analyst at Vanguard. “We've found pretty consistently over time that the vast majority of active bond portfolio managers can't even do it,” he said. “If you're an adviser without the same tools, that's a huge hurdle to overcome.” Holding on to investment-grade bonds is still going to take a strong stomach. Vanguard looked at what would happen to a portfolio of investment-grade bonds if rates were to rise 300 basis points — considered the worst-case scenario today but not the biggest single-year increase ever. The year of the rise wouldn't be pretty. The portfolio would lose about 13%.

"BACK IN BLACK'

After two years, though, with interest payments reinvested, the total return would be -8.5%. In fact, the longer the portfolio were held, the rosier things would get. After the fifth year, the portfolio would have a total return of 6.3%. “If you're reinvesting dividends, you can be back in black in a fairly reasonable amount of time,” Mr. Phillips said. The good news is that there is no driver in the market that could lead to that kind of worst-case scenario at this time, he said. “You have to think about the likelihood that rates continue to go up, making cash the true loss avoidance vehicle you think it would be,” Mr. Phillips said. Inflation looks tame, and with Europe in a recession, Japan's problems and emerging markets struggling from little global growth, the United States still looks like the best bet in the world, meaning that rates probably aren't on a skyward trajectory at the moment, he said.