A gusher for bonds, but what lies ahead?

Investors have reacted to the past year's severe downturn in stocks by loading up on bond funds at a staggering rate. According to the Investment Company Institute, they poured $220 billion into bond funds during the first eight months of 2009, compared with just $27 billion during all of 2008.

One of the lures is the greater stability that bond funds have historically offered compared with stock funds, especially during 2008's brutal market experience: The S&P 500 Index returned about –37%, while the broad bond market returned about 5%.*

Another attraction is bonds' history of higher yields compared with short-term investments such as money market instruments. The Federal Reserve is keeping short-term rates at all-time lows. So while bonds' longer-term yields have dropped since last year, they're still substantially higher than short-term yields.

Not all bonds are alike

Of course, bond investments have their own challenges, and one that they all share is sensitivity to interest rate changes: Bond prices fall when interest rates rise (and the reverse).

A bond sector's unique characteristics also affect bond performance. Attributes such as duration (a measure of sensitivity to changes in interest rates), credit quality, and maturity can vary greatly, which means that various sectors don't move in tandem.

A brief comparison of 2008 with the first nine months of 2009 illustrates how quickly conditions can change. It also underscores the wide range of performance among the fixed income market's various sectors:

Treasury securities. Last year's fears about the future of the financial markets and the economy produced extraordinary demand for the perceived safety of U.S. Treasury securities, but investors spurned them this year for riskier investments—thus reducing demand and returns.

Treasury Inflation-Protected Securities (TIPS). TIPS, which seek to counter purchasing power lost from inflation, declined in value when investors feared deflation and the brake it could put on any economic recovery. After the government instituted an aggressive set of stimulus policies, investors concluded that muted inflation was more probable, and TIPS rallied.

GNMA securities. GNMA securities represent pools of residential mortgages whose principal and interest are guaranteed by the government. This guarantee kept returns near those of Treasuries in 2008. The additional yield that GNMA securities offer over Treasuries, along with greater confidence in real-estate-related investments as the economic outlook improved, led to better-than-Treasury returns in 2009.

Corporate bonds—investment-grade. Investment-grade corporate bonds suffered when investors feared a massive wave of corporate bankruptcies. As those concerns eased, bond returns surged.

Corporate bonds—high-yield. Lower-quality bonds—often known as "high-yield" or "junk" bonds—also fared poorly in 2008. By contrast, they were the best-performing fixed income group in the succeeding nine months' more risk-forgiving environment.

Municipal bonds. The returns of tax-exempt bonds declined last year as fears of a weak economy increased the perceived credit risk of municipal bonds. Later in the year, the financial crisis forced some investors to raise cash by selling their municipal bond holdings. This year, municipals rallied as demand resurfaced—even though recession concerns (generally unwarranted in our view) hung over the sector.

What could go wrong?

Most corporate-bond issuers have weathered the recession, but the anemic economic recovery that many people expect could pose a threat to some companies. And even though bonds generally looked good through September 30, trouble for them could arise from monetary or fiscal policy, or both.

The decline in U.S. interest rates over the past two years has helped support bond prices, and Vanguard economists believe that the Fed is unlikely to push U.S. interest rates higher in the near term. But as the economy recovers, the Fed will most likely try to nudge interest rates higher in an attempt to preempt a spike in inflation.

Indeed, many people expect the federal government to issue massive amounts of bonds to finance its stimulus package and large projected deficits. This could put upward pressure on interest rates.

Although interest rates seem unlikely to rise much in the short run, it's worth asking what might happen when they do. The answer depends largely on a bond's duration. (Remember that the longer the duration, the greater the sensitivity to interest rates.) For example, the average duration of short-term government and investment-grade bonds is about 2.5 years, meaning that a 1-percentage-point increase in interest rates will produce about a 2.5% decline in price. The average duration of their intermediate-term and long-term counterparts is about 3.9 years and 12 years, respectively.**

As we've seen, short-term performance can fluctuate and can defy prediction. Moreover, chasing performance makes it easy to fall into the trap of selling one asset class at a low point and buying another at a high one.

* Barclays Capital U.S. Aggregate Bond Index.

** As of September 30, 2009: Barclays Capital U.S. 1–5 Year Government/Credit, U.S. Aggregate Bond, and U.S. Long Government/Credit indexes.

Notes:

• All investments are subject to risk. Investments in bonds are subject to interest rate, credit, and inflation risk.
• Because high-yield bonds are considered speculative, investors should be prepared to assume a substantially greater level of credit risk than with other types of bonds. While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates.
• Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
• Diversification does not ensure a profit or protect against a loss in a declining market.
• Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
• An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.
• The performance data shown represent past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so that investors' shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. You can view current month-end-performance data and standardized performance (1-, 5-, and 10-year returns) and expense ratio information.