Source: U.S. Treasury.
The stock market has performed well throughout 2014, and even Tuesday morning's minor pullback in the major market benchmarks wasn't enough to throw cold water on the year-end celebrations of another winning year on Wall Street. As of noon EST, the Dow Jones Industrials (^DJI 0.69%) had eased downward by 44 points, losing their grip on the 18,000 level but nevertheless remaining securely fixed to solid gains on the year.
Yet as impressive as the six-year bull market run for stocks has been, an even bigger surprise this year came from a completely different corner of the investing world: the bond market. Bonds didn't just defy expectations for declines; they soared as interest rate moves defied investors' expectations.
Why the bond bust didn't happen
Coming into 2014, most investors were nervous about the prospects of the bond market this year. Near the middle of 2013, the Federal Reserve had warned investors that it was planning to start reducing its bond purchases under its quantitative easing program, and the response in the bond market was a steep upward surge in interest rates and a sharp decline in bond prices. The iShares Barclays 20+ Year Treasury ETF (TLT 0.03%), which invests in long-term Treasury bonds, fell almost 14% between the beginning of May and the end of August last year, reflecting the wide-held belief that long-term rates were destined to soar once the Fed stopped stimulating the economy through bond-market purchases.
Yet the much-expected decline in interest rates never came to pass. A loss of confidence in the stock market in early 2014 sent many investors running for cover in bonds, and after posting solid gains early in the year, long-term Treasuries never looked back. Even as the economy continued to recover and the ever-slowing pace of Fed bond purchases eventually waned to zero, policymakers kept stressing their intention to keep future interest rate increases slow. That gave bond investors the assurances they needed to keep their asset allocations stable, and the iShares Treasury ETF has climbed to gains of 24% in 2014, easily eclipsing the Dow's 8.5% gain.
U.S. Treasury Building, Washington, D.C.
Global economic pressures also helped support the Treasury market. The strength of the U.S. dollar led many foreign investors to protect their investments by buying dollar-denominated assets, and sluggish growth in Europe and Japan sent overseas bond yields lower, pulling down American bond yields along with them. Throughout much of the year, the additional yield available from U.S. bonds compared to German sovereign debt was near its highest levels in 15 years, and foreign interest in Treasuries played an important role even as many expected those spreads to increase in the near future.
What's ahead for bonds in 2015?
With long-term rates having fallen by more than a percentage point to less than 3%, it would take a lot for the bond market to produce anything close to its 2014 gains next year. With yields so low, nearly all of the total return potential in bonds comes from capital appreciation, rather than interest, and even at their lowest levels during the financial crisis, 30-year yields never fell far below the 2.5% mark.
If interest rates turn around and start rising, then 2015 could be a terrible year for bonds. Yet that's exactly what many analysts predicted for 2014. Prudent rebalancing of your portfolio to avoid excessive bond-market risk is a smart move, but you shouldn't bet everything on a bond-market crash in 2015.
