The best bond funds in 2014 posted returns of more than 40 percent betting on long US Treasury bonds, a strategy that had scant support when the year began. Still, a repeat performance in 2015 is unlikely, investors said.
Long-dated funds topped the list of best bond performers in 2014, as investors in securities with maturities greater than 10 years reaped the reward of a surprising rally in long-dated debt at a time when most observers expected yields to rise, rather than fall. Bond yields fall when prices rise.
The long bonds have come storming out of the gate in 2015 - the Barclays US Treasury 20+ Year Index has gained 4.3 percent in just a few days so far this year, so last year's winners are taking something of a victory lap.
Whether this lasts depends on oil prices, the strength of the dollar, and when the Federal Reserve decides to boost interest rates, among other things. Some investors say the slumping oil price that's fed deflation fears will eventually recover, making it more likely that long yields will rise, even if modestly, in the coming year.
In that case, long-dated maturity funds will struggle, said Josh Barrickman, head of Vanguard bond indexing Americas, who also helps manage the Vanguard Extended Duration Treasury Index Fund, the best performing bond fund in 2014.
"If rates go up, it's going to underperform, no question about it," he said.
The low-cost Vanguard Extended Duration fund returned 46 percent in 2014, according to preliminary data from both Morningstar and Lipper, a Thomson Reuters unit.
The passively-managed fund tracks the performance of the Barclays US Treasury STRIPS 20-30 Year Equal Par Bond Index and has an average effective maturity of about 25 years.
Other long-duration funds rounded out the top three: the PIMCO Extended Duration Fund, up about 45 percent, and the Wasatch-Hoisington US Treasury Fund, up about 32.6 percent.
The 30-year US Treasury bond, for example, ended 2014 yielding 2.75 percent. A move higher of just 25 basis points in 2015 could mean roughly a 2 percent total loss on those bonds. So far this year, the 30-year has rallied, and was yielding 2.56 percent on January 07.
Federal Reserve policymakers have signalled that they are considering a rate hike later in the year. But even if Fed rates rise, active managers in long-dated funds say the long end of the curve could still stay low or even rally as long as inflation expectations are contained.
Economists at Wall Street's biggest banks said they see the Fed raising rates by June, with a median view that the bank will boost its key rate to 1 percent by year-end, according to a December poll by Reuters.. Fed minutes released on January 07 showed that policymakers last month pressed ahead with plans to begin raising interest rates later this year, but that they also acknowledged subdued price pressures and darkening economic outlooks for the euro zone and Japan.
Alternatively, managers could tinker with the duration in their funds. Duration is a way of measuring how sensitive a bond is to interest-rate rises. The longer the duration, the worse the performance if rates rise.
But even then, the funds might simply underwhelm, said Sarah Bush, senior manager research analyst at Morningstar. Many of those funds are designed for institutions looking to match liabilities, for example, which means they could stay long through a cycle of rate hikes.
"If we do see a rise in long term yields you're going to see losses in those funds," she said.
After last year's rally, she said, "you're getting paid less to take that interest rate risk than you were a year ago - and there's a lot of interest rate risk."
Not everyone sees it that way.
Van Hoisington, the portfolio manager of the Wasatch-Hoisington US Treasury fund, said 30-year Treasury yields could keep going lower in 2015 if price pressures stay muted.
He pointed to yields in other developed nations - 1.17 percent for 30-year Japanese bonds, 1.148 percent in Germany - as suggesting that US yields could still fall further.
The dollar has risen 15 percent against a basket of major currencies since the beginning of 2014. A stronger dollar helps the Fed fight inflation, since it allows Americans to import more goods from abroad - extra goods that, in boosting supply, can help dampen price pressures.
"We understand we're contrarian," Hoisington said. "That's also what makes you money."
Hoisington said he's ready to change his stance if he's wrong. "We could go shorter" in duration than the benchmark index, he suggested. In the past, he noted, he's gone to "a duration of basically zero" to deal with rising inflation, though not in this specific fund, which reduces the risk of long-term bonds.
The Fed's last cycle of rate hikes began in 2004 and ended in 2006. For those three years, the Wasatch-Hoisington fund returned 21.6 percent, compared with an 11.5 percent return for the Barclays Capital US Aggregate bond index in that three-year stretch.
Neither the Vanguard nor Pimco funds were open over those years. But the Vanguard fund's top performance also underscores the potentially uphill battle that some managers face in convincing investors to pay more money for active management.
Active management typically costs more than passive management. The Vanguard fund carries expenses of 10 basis points, according to Morningstar. The Pimco fund carries expenses of 50 basis points.
Steve Rodosky, the manager for the Pimco fund, in an email, said that active management "will be able to react to different environments to better protect the value of client assets."
"The bull market for long dated assets won't last forever," he said.
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