In what's been a rude awakening for some investors, bond funds have lost ground these past couple of weeks, unlike in past downturns for stocks. What's different this time is that the same things undercutting stocks are hurting bond prices: worries about inflation and the possibility of much higher interest rates.
Bond losses have been more modest than the setback for stocks, but more may be on the way. And swings in bond prices are likely to become more common than in recent years, when returns were unusually smooth, experts say.
Nevertheless, experts are sticking with the mantra that bonds will be safer than stocks and that investors can continue to count on them as a stabilizing force for their portfolios.
Ken Mahoney, president of Mahoney Asset Management, said he has been hearing from clients this week who were surprised by the struggles for bonds.
"They kind of say, 'I thought when stock prices go down, bonds go up?'" he said.
Instead, while stocks were dropping 10 percent from their record high, set on Jan. 26, the largest bond mutual fund lost 0.8 percent through Thursday.
The spark that sent markets tumbling was a report last week that showed wages in the U.S. are rising faster than expected. That raised concerns that inflation may be on the way up, which could force the Federal Reserve to increase interest rates more quickly than expected.
When the Fed raises rates, bonds typically begin paying more in interest. That's good for investors who buy those more lucrative, newly issued bonds. But the old bonds sitting in bond funds' portfolios see their prices drop, because they suddenly look less attractive than the new ones.
Inflation, meanwhile, is one of the worst enemies for bond investors, because it dilutes the value of the fixed payments that bonds make.
Even before the inflation worries flared, bond fund investors were jittery because the Fed has been slowly winding down the measures it took to stimulate the economy during the Great Recession. The Fed is raising short-term interest rates and reducing its large holdings of bonds.
Because of that, investors need to recalibrate their expectations for how steady bond funds can be, particularly after the unusually calm stretch that investors have enjoyed.
The index that many traditional bond funds measure themselves against, the Bloomberg Barclays U.S. Aggregate, has had one loss in the last eight quarters. Going back to 1980, the index has had a loss about 20 percent of the time, or one in five quarters.
"People have become quite trained on seeing only positive returns from their bond funds," said Mike Dowdall, investment strategist at BMO Global Asset Management. But he said negative returns are to be expected every now and then.
And "that's OK," he said. Bonds and bond funds are "still going to provide income, and it still makes sense to have that diversification."
Even if rates rise, experts say it's very unlikely that a bond fund would have losses as sharp as stocks are capable of. Bonds make regular interest payments, which helps steady their returns. And if a company goes bankrupt, bondholders are ahead of stock investors in the line to get their money back. U.S. government bonds, meanwhile, are considered virtually free of risk of default.
That's why bonds rallied in 2011, when stock markets around the world tumbled on worries that Europe's debt crisis would tear apart the European Union, in 2008, when the financial crisis hit its depths, and in 2000, when the dot-com bubble was bursting.
If the upcoming rise in rates is a smooth one, the increased payouts that bonds will make could help offset the drops in price that bond funds suffer and smooth out returns, said Chris Brown, a portfolio manager at T. Rowe Price.
That's why he suggests investors muddle through the volatile patches, such as the last couple of weeks where both bond and stock prices went south.
"On any given day, you might see the relationship flip on its head, where bonds go down and stocks go down," he said. "This week has been pretty topsy-turvy, but on the worst days (for stocks), you saw bonds do exactly what you thought they would do: They rallied."
The next big test for the bond and stock markets could be on Valentine's Day, when the government releases its next monthly update on inflation.
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