The Disappointing Dow Boosts Bonds -- For Now

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

So far this year, the performance of the Dow Jones Industrials (DJINDICES: ^DJI  ) has been a big disappointment to bullish investors, with the average down another 68 points just before 12:30 p.m. EST to bring its total decline for 2014 to more than 100 points. But what's been bad for stocks has been good for bonds, as the bond market has largely seen rates stabilize and prices rise modestly in the first week of the new year.

How 2014 has treated bonds
Many investors came into 2014 expecting the rout in the bond market to continue. With the Federal Reserve having begun to reduce its quantitative easing program, bond yields had climbed substantially, hurting bond prices and leading to negative total returns for many bond investors in 2013.

So far this year, though, most niches of the bond market have held up reasonably well:

  • Treasury bonds have held their own, with 10-year yields remaining at roughly the 3% mark. The iShares 20+ Year Treasury Bond ETF (NYSEMKT: TLT  ) , a benchmark for long-term Treasuries, has risen about half a percent so far on the year.
  • Expectations for inflation have remained subdued, and that has held rates on inflation-adjusted bonds relatively stable as well. The iShares TIPS Bond ETF  (NYSEMKT: TIP  ) has also posted gains of about 0.4% in 2014.
  • Among smaller niches, municipal bonds have seen similar gains, while high-yield corporate bonds have risen a bit less. The SPDR High Yield Bond ETF  (NYSEMKT: JNK  ) has gained 0.2% for the year, while one popular benchmark of muni bonds has risen about half a percent in 2014.

Will the good times last?
Obviously, with only five trading sessions under our belt, it's too early to make any dramatic conclusions about the fate of the bond market in 2014.

Moreover, the mood in the bond market could change as early as this afternoon, when the Federal Reserve releases the minutes of its key December meeting, at which it first reduced the amount of its bond-buying activity from $85 billion monthly to $75 billion. If the minutes give hints about the pace at which the Fed could make future reductions in buying bonds, the impact on the market could be huge. Strong economic data has led many to believe that the Fed could reduce its bond buying all the way to zero by the end of 2014. But if the minutes suggest a more gradual reduction, the greater volume of bond purchases could pull long-term rates back downward somewhat, producing gains for long-term bond investors.

In the long run, the Federal Reserve has made it quite clear that although it's ready to maintain extremely accommodative monetary policies for whatever period is necessary to return the economy to a normal course, it still expects to return to a more standard policy in due time. Sooner or later, that will likely lead to further gains in interest rates, putting bond investors in the uncomfortable situation of waiting for almost inevitable capital losses from holding bonds. Only by preparing for rising rates by using more defensive strategies can you preserve your capital for the bond portion of your overall portfolio.

Don't just count on bonds
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