Traditional bond investors may need to brace for lower returns, or even losses, this year if some financial advisers' assessments are correct that bond prices will suffer as the economy continues to improve and the Federal Reserve continues to taper its stimulus program.
"As the economy strengthens, the demand for money increases and this increased demand places an upward bias on interest rates," said Bob Hapanowicz, president of Hapanowicz & Associates, Downtown. "This will lead to falling bond prices, as bond prices move inversely with interest rates.
"During 2014, bond investors will likely experience flattish total returns, as interest earned from bonds will be offset by declining prices."
While many financial advisers do not expect bonds to deliver much this year in total returns, the good news for patient bond investors is that rising interest rates will ultimately bode well for returns in the future.
Although the stock market gained 30 percent in 2013 and bonds posted a 2 percent loss (the worst performance since 1994), the first few weeks of 2014 have provided a convincing reminder of the effectiveness of bonds as a diversification tool.
Stock markets have lost about 3 percent, while bonds have delivered a positive return of about 1.2 percent.
Riskier bond investments, such as foreign bonds and junk bonds, are yielding much higher returns -- 10 percent or more -- because those rates have been driven up by yield-hungry investors. But traditional bond rates remain low by historical standards.
"Although volatility could rise in 2014, investors should consider equities as a hedge to rising rates and for longer-term returns, and should count on fixed-income assets to diversify their portfolios," said Mike Maglio, an adviser at PNC Wealth Management, Downtown.
Mr. Maglio also expects the Federal Reserve to scale down its purchase of Treasuries and mortgage-backed bonds, which will cause the interest rates on longer maturity bonds to rise.
"As a natural reaction to the diminished bond-buying by the Fed, we expect the 10-year Treasury rate to climb from 2.75 percent to 3.47 percent during 2014," Mr. Maglio said.
Benjamin Sullivan, a portfolio manager and financial planner at Palisades Hudson Financial Group in Scarsdale, N.Y., said rates are still too low and risks too high to invest in longer-term bonds. But short-term bonds -- with maturities of one year or less -- do belong in a portfolio. Short-term bonds have lower yields, but they have less downside risk.
"Safety is what you want in bonds," Mr. Sullivan said. "Bonds in a portfolio reduce volatility, cover short-term cash needs and preserve dry powder to deploy opportunistically in a market downturn. If you'll need to withdraw money from your portfolio within the next five years, cash or bonds are needed.
"Even aggressive investors should own some bonds because they have a low or negative correlation with stocks," he said. "In every year since 1977 in which large U.S. stocks have had negative returns, the bond market has had positive returns of at least 3 percent."
Tim Grant: email@example.com or 412-263-1591.