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.
The S&P 500 (SNPINDEX:^GSPC) has had a bad start to 2014, with Friday's 2.1% plunge bringing the index's losses for the year to more than 3%. After a five-year bull-market run, minor losses shouldn't be all that extraordinary. But what's really surprising investors is the strength that they're seeing in a completely unexpected corner: the bond market. Let's look at bonds and why they're doing so well in 2014.
The big boom in bonds that no one predicted
Last year was big for two reasons: The S&P 500 posted its best performance since the 1990s, and soaring interest rates caused big losses for bonds. With the Federal Reserve having just started its tapering from its quantitative easing program, most analysts expected interest rates to continue rising, putting even more pressure on bond prices.
But so far this year, that hasn't happened. Look at what we've seen from various parts of the bond market:
- Long-term Treasuries were among the hardest hit in 2013, but the iShares 20+ Year Treasury ETF (NASDAQ:TLT) is up 5.5% already just in January.
- Signs of inflation remain muted at best, but inflation-adjusted bonds have still gained ground, with the iShares TIPS Bond ETF (NYSEMKT:TIP) jumping almost 2%.
- Many investors wrote off municipal bonds after the bankruptcy of Detroit, arguing that risks were too high. But the iShares National AMT-Free Muni ETF has gained almost 2.5% in January, and many popular leveraged closed-end funds have had even better performance.
- Even high-yield junk bonds, which often correlate better with stocks than bonds, have held up well, with SPDR High-Yield Corporate (NYSEMKT:JNK)posting small rises of less than 1% rather than following the stock market downward.
Meanwhile, yields on bonds have fallen rather than continuing to rise. The 10-year Treasury yield has fallen by more than a quarter percentage point, from above 3% at the beginning of the year to 2.73% on Friday.
The impact on consumers has thus far been relatively small. Thirty-year mortgage rates have fallen from 4.53% three weeks ago to 4.39% as of Thursday, and the drop in Treasury yields in Friday could send mortgage rates still lower when they get reported next week.
But the lesson investors need to take from the strong performance of bonds is that even when diversification seems like it doesn't make sense, it can end up paying unexpected dividends. Many investors chose to give up on bonds after their terrible performance in 2013, but January's returns show that diversified portfolios can lead to smoother results than betting on a single asset class -- no matter how much of a no-brainer it might seem to be.