For the past decade, bonds have dodged a bear market. Has their luck finally run out? The bond market faced rough waters in 2021, down 1.5%.* With the latest coronavirus variant prolonging supply shortages…inflation running hotter than expected…and interest rates likely to rise, driving down bond prices…the reckoning could be painful for investors. There’s a potential for a second losing year in a row, which hasn’t happened in government bonds since the 1950s.

Bottom Line Personal asked bond-fund strategist Robert M. Brinker to discuss the outlook for bonds—and to identify which types of bonds to avoid and which bond funds are likely to do well…

Take Credit Risk, Not Interest Rate Risk

Bonds are going to face a challenging year due to a confluence of factors that we haven’t seen for many years, including…

Continued robust US economic growth. Gross domestic product (GDP) growth is likely to reach 3% to 4% this year, driven by ongoing pent-up demand from US consumers.

Inflation will remain elevated. While I don’t see inflation continuing to accelerate the way it did much of last year, it won’t be transitory either. As measured by the Consumer Price Index, the inflation rate will settle in the 3% range, nearly double what it has averaged over the past decade. Even if chronic global supply shortages fade, labor shortages and higher employee wages will help keep prices high.

Interest rates will rise as the Federal Reserve tries to keep inflation in check. I foresee at least two short-term rate hikes. The Federal Funds rate will end the year in a range of 0.75% to 1%, up from a recent range of 0.0% to 0.25%. As for long-term rates, I expect the yield on 10-year US Treasuries—recently 1.52%—to climb as high as 2.4% by year-end. Many areas of the bond market likely will see negative returns this year. But if you pick your spots carefully, bonds still can serve their two most important roles for you—they can provide better total returns (yield + capital appreciation) than cash and allow you to keep up with inflation…and they can stabilize your portfolio against up-and-down stock market swings, which I think will be significant in 2022 because S&P 500 valuations are stretched after three consecutive years of double-digit gains.

My strategy for 2022: Stay away from plain-vanilla bonds. Focus on fixed-income investments that have a history of doing well in inflationary environments. That means bonds with short-term maturities—because the longer the maturity, the more a bond’s value falls as interest rates go up. Also, favor bonds with lower credit ratings because they offer better yields than high-quality bonds and the companies that issue them are less likely to default on their loans now thanks to a strong economy.

Bond Types to Avoid

The following areas of the bond market look particularly unappealing this year, either because they will be hit hard by rising interest rates…their meager yields don’t justify the risks…or they are overpriced and unlikely to provide a decent total return.

Long-term government bonds typically have maturities from 10 years to 30-plus years. They lost 4.4% in 2021 and offered a recent yield of 1.7%. Even a modest rise in interest rates could have a devastating effect on these bonds. Reason: They have an average “duration”—a measure of how sensitive a portfolio of bonds is to changes in interest rates—of 19 years. That means if long-term rates rise one percentage point, the value of these bonds would drop 19%.

Short-term government and short-term corporate bonds, with maturities of one to three years, lost 1.1% in 2021. While they have a duration of just two years, they offer only a 0.5% yield. Very conservative investors looking to safely park cash may be better off with a one-year CD (recently 0.88%) or an FDIC-insured savings account (recently 0.65%) whose yield will go up as interest rates rise.

Treasury Inflation-Protected Securities (TIPS). These bonds—which are issued by the US government and indexed to inflation to protect investors from a decline in the US dollar’s purchasing power—had a terrific year with a gain of 5.7% and a recent average yield of 4.3%. So why aren’t I more enthusiastic? The yield offered by TIPS is derived from a formula that includes a base rate that the government pays plus the rate of inflation. Last year, so many investors poured into TIPS that their prices are greatly overvalued and the base rate on a 10-year TIPS was recently about –1%.

Emerging-market bonds. Many investors flock to these risky, overseas bonds because of generous yields, recently in the 4% range. But the category’s performance was down 2.3% last year due to sluggish post-pandemic recoveries in many foreign nations and a strong US dollar, now at about 18-month highs. I believe those trends will continue and weigh on these bonds’ returns in 2022.

Bond Funds to Favor

The following four no-load mutual funds look attractive and can provide solid total returns for the type of financial environment I expect in 2022, including rising interest rates, low defaults and a still-strong economy and housing market…

DoubleLine Total Return Bond Fund (DLTNX) is run by Jeffrey Gundlach, arguably the best manager in fixed-income markets today. The fund invests in more than 2,700 mortgage-backed securities bonds composed of large bundles of residential mortgage loans. These securities do well when the housing market is strong and unemployment is improving because their yields come from the interest homeowners pay on the mortgage loans. Gundlach uses a “barbell” approach, typically mixing very stable, low-yielding mortgage securities backed by federal government agencies with carefully selected “non-agency” securities composed of riskier mortgage loans with higher yields. Recent yield: 2.87%. 10-year performance: 3.3%.

Fidelity Floating Rate High Income Fund (FFRHX) specializes in bondlike securities known as bank loans made to corporate borrowers. These very short-term, adjustable-rate loans don’t have a fixed payout rate as most bonds do. Instead, the rates reset every 30 to 90 days so the securities keep pace if interest rates rise. I expect this to be one of the better-performing bond categories in 2022. Although most floating-rate securities are rated below investment-grade, the Fidelity fund, with 600-plus holdings, takes a conservative approach. It sticks with loans made to large companies that generate lots of cash flow, giving them the ability to avoid defaults. Recent yield: 3.26%. 10-year performance: 3.9%.

Loomis Sayles Bond Fund (LSBRX). For two-and-a-half decades, this eclectic multisector fund with about 500 holdings has excelled in a variety of economic and bond environments. It can hold almost any type of investment that offers income, including currencies, stocks or bonds, regardless of the length of maturity, credit quality, type of issuer or country. Lately, the fund has kept one-quarter of its assets in junk bonds, and another 10% in dividend-paying stocks that are bets on a resurging economy and high inflation such as Chevron, United Parcel Service and Union Pacific Railroad. Recent yield: 2.64%. 10-year performance: 4.5%.

Osterweis Strategic Income Fund (OSTIX). This fund was one of my favorites for 2021, and it produced a 5.5% gain. Many junk-bond funds don’t offer enough yield given the credit-quality and interest rate risk they entail, but this one offers a unique strategy. It focuses on about 180 mostly short-term bonds with an average duration under two years. The fund further mutes volatility by holding large amounts of cash if manager Carl Kaufman can’t find attractive investments. Kaufman excels at evaluating credit risk. Since the fund’s 2002 launch, none of its bond holdings has ever experienced a default. Recent yield: 4.03%. 10-year performance: 5.1%.

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