The turnaround in the stock market in 2009 pushed returns to the best year since 2003, with the S&P 500 Index gaining about 26 percent. This was even more impressive than a first glance might indicate when you consider the index was down more than 20 percent to start the year before the recovery began in mid-March.
Even more impressive was the performance of the corporate bond market which enjoyed gains in ’09 better than any year in memory. The fantastic recovery was made possible by the fire sale of 2008 where bonds issued by corporations which had any chance of trouble surviving a severe economic downturn were dumped at prices ranging from 40 to 70 cents on the dollar.
The wave of fear and associated panic selling created an opportunity for those who could see through to the other side of the financial crisis and that the world was not ending. Owning bonds at very cheap prices can produce returns similar to stocks when the fear passes and investors clamor for bargains on depressed securities. The result? A year where the average high quality corporate bond fund gained 15 percent and where many high yield bond funds gained more than 50 percent.
As this wave of great performance unfolded during the year, investors eagerly moved money into this segment of the fixed income markets. Bond funds took in more than $200 billion as investors clamored for great returns with more predictability and security than stocks could provide.
Investors who moved early on this trend were smart. Obtaining returns on par with the equities market through ownership of a vehicle which has more security than owning stocks is a great idea. Unfortunately, the time periods when this is possible are relatively short and you have to recognize them quickly.
Of course, the pendulum swings both ways.
When investors get too excited about one segment of the market, prices rise and eventually do not provide a compelling value. In fact, the recovery in the corporate bond market has now brought prices on high quality bonds back to levels considered normal before the crisis of 2008 occurred.
This doesn’t mean there is a looming problem, but it does mean that investors should not expect a repeat of the returns we saw last year for bonds.
In fact, it is a virtual impossibility for a repeat of last year’s gains because the yield spreads between corporate bonds and treasury bonds must shrink to allow for the additional capital gains that boost the returns.
With spreads already at or near historically normal levels, this is just not going to happen.
In summary, now is a time to own bonds to earn the interest income they produce and don’t expect huge capital gains over the next year or two.
Tom Breiter, the president of Breiter Capital Management, Inc., is a registered investment adviser. He can be reached at (941) 778-1900 or by e-mail at: firstname.lastname@example.org