When 2020 began, investors were coming off a strong year for the stock market and hoped that the good times would continue. Markets obliged those optimistic views for a while -- until coronavirus fears sparked the fastest correction in stock market history, sending Dow Jones Industrials (^DJI) down thousands of points in a single week.
Yet even as stocks lost all their gains for the year and continued lower, another asset class kept up its surprising run of outperformance. Year after year, the bond market has managed to dodge bullets and produce solid returns for investors. Despite bond yields already being at rock-bottom levels, investors' worries about the Covid-19 outbreak managed to push those yields still lower, producing double-digit percentage gains for bond investors to offset their stock market losses.
What goes down keeps going down
Bond market watchers have been nervous about the long-term prospects for bonds for a long time. Rates on long-term 30-year bonds stayed below 4% throughout most of the 2010s, and every time it's looked as though the economy might start to heat up, bond investors have grown concerned that even modest increases in long-term rates could cause a big drop in bond prices. That's what happened in the second half of 2016, when the iShares 20+ Year Treasury ETF (TLT -0.56%) lost nearly 20% over the span of just a few months when long-term rates jumped from around 2.25% to above 3%.
More recently, though, interest rates have defied predictions. In late 2018, it appeared that the Federal Reserve might continue to raise short-term interest rates, which had pushed yields to their highest levels in years. Yet the Fed abruptly did an about-face and cut rates when it appeared that economic sluggishness might stall out the recovery. Now, with the coronavirus raising all kinds of uncertainty about the future of the global economy, investors have sought whatever safe havens they can find. Long-term Treasury bonds have been the answer, sending rates to historic lows and bond prices soaring.
Long-term bonds are especially sensitive to rate movements, which explains how they can produce gains of 13% even when they're yielding less than 1.75%. Because the existing holdings of the long-term Treasury ETF have fixed rates, their prices go up when prevailing rates go down, because the relatively higher interest payments they make look more attractive in a lower-rate environment.
The danger of bonds
Bonds have traditionally played a key role in balancing investors' portfolios. It's not uncommon for stocks and bonds to move in opposite directions, as they've done lately, helping to offset each other's moves and produce smoother gains over the long run. That's why you'll typically find bonds prominently included in asset allocation strategies.
The challenge going forward, though, is that at current yields, bonds do almost nothing for investors in terms of providing current income. Bonds will be able to perform the way they have in the past only if yields keep trending lower. Although Europe's bond yields have gone negative, there's still only so far investors can expect Treasury yields to fall before bouncing back upward.
Naysayers about bonds have been wrong for a long time, and it's possible that they'll be wrong again. Nevertheless, if the coronavirus-led downturn in the stock market turns out to be short-lived, the success that bonds have had recently could reverse itself quickly -- bringing a nasty surprise to those who thought Treasuries were conservative investments that could never lose money.