Notwithstanding the past few weeks, the returns on almost all types of bonds funds over the last decade have been better than many would have expected. For example, here are the 10 yr. ann. total returns on all of the specific bond funds included my current Model Bond Portfolio:

Aggressive bond investors likely have seen even higher returns. For example, emerging markets bond funds have averaged 11.8% per year over the above 10 year period while a "zero coupon" Treasury bond fund such as American Century 2020 (BTTTX) has returned 8.6.

These types of funds, whose results were not as high, for the most part, as investors might had hoped for as compared to their former expectations for stocks, did prove to be valuable portfolio components since stocks obviously had a subpar decade. So, for example, the S&P 500 Index has returned only 0.6 over the above period. Cash, as represented by the average MM fund was a poor second at about 2.0.

And, once again looking past the past few weeks, bond gains have generally picked up even more over the last year than their 10 yr. averages. But what's past is past. The question for today is can investors in bonds continue their chant of "We're number 1" over the next few years?

As can be seen from the data above, there has been a good deal of variation in the size of returns depending which type of fund (and specific fund within its category) one chose. Of course, this will always be the case, just as there will always be variations in stock fund results depending on such choices. So it pays to think not just in terms of bond funds in general, but which ones one should focus on. So, for example, over the last decade, it would be safe to say that longer term bonds have done a little better than shorter term ones, and high quality bonds have done better than lower quality ones.

We address which specific bond funds we recommend in our quarterly Model Bond Portfolio. In this article, we will give our overall appraisal of the bond market.

Current Bond Market Prospects

In a nutshell, we do not expect bond funds to keep up the above pace over the next few years. Here's why.

• As discussed previously in this Newsletter and should be apparent to most everyone, interest rates are multi-generational lows. This means dividends from funds, the main source of returns in bond funds, are nowhere near as generous as even a few years ago.

  And with interest rates already so low, there are few opportunities for capital gains which form the second piece of bond fund investors' potential returns. Such gains would result only if rates dropped even further resulting in higher bond prices which might be captured by aggressive investors. (If prices rose only temporarily and then returned to from whence they started, only investors who sold at the higher price would realize a capital gain. Buy and hold investors, in other words, would wind up being no better off by a relatively temporary drop in interest rates.)

  If interest rates go up in the years ahead, which is more than likely, investors will, at least initially, see losses in total return, as capital losses take back more in return than the extra dividends to be earned. Eventually however, the higher dividends will finally offset the losses and the long-term bond fund investor could come out ahead quite a bit down the road.

• There is a danger that some bonds, especially government bonds (including Us municipal bonds), will suffer if the issuing entities are seen as becoming more and more unable to escape from too much debt. Investors may demand higher interest rates to compensate for the risks that a) interest rates may rise more than expected, diminishing the value of existing bonds and b) even worse, that these entities may be unable to pay back these obligations. These fears, or actual debt crises, will likely translate into lower bond prices. Of course, greater issuance adds to supply which can also result in lower bond prices.

• Foreign investors who now buy and own a considerable portion of US Treasury debt may cut back or even start to withdraw funds. Why? Not only because better returns are currently available in other countries' bonds, but as a result of projecting actual losses which they may wind up with if the US dollar drops further as it has been (and which the Fed is subtly "encouraging" thru its $600 billion quantitative easing, or "QE2", program). And some have suggested that if the US's role as the primary economic power in the world diminishes in the years ahead, other governments' central banks who traditionally looked to the US dollar as the main "reserve currency" will diversify their holdings away from US bonds.

• Finally, the Fed's earlier round of QE has resulted in investors fleeing many types of bonds, especially shorter-term ones, because they are looking for higher future returns.

  Will the new QE2 have the same result? While it is too early to say for sure, the Fed remains a powerful force in the US economy and its influence and resolve (including perhaps doing even more easing, if necessary) to achieve its results, should not be underestimated. (Thus, the investing axiom: "Do not fight the Fed," meaning it is usually a losing proposition to assume, as at least some people are currently doing, that one can safely infer that the Fed will not be able to influence the economy in the way it wants.)

Caveats

Of course, not everything is bleak for bonds. Here a few reasons why at least some types of bonds might continue to do reasonably well:

• As "baby boomers" continue to age and begin their retirement, many of the boomers' current stock investors will wish to ensure a more stable and reliable source of income for their non-working years. Stocks, especially over the last decade, certainly have been far too volatile to consistently provide the resources needed to live off in retirement. This may be part of why data show that since early 2009, investors have added significantly to their bond fund positions while greatly reducing their ownership of traditional stock funds, even as stock funds have enjoyed a strong bull market over that period.

• Of course, while QE2 may not result in a long-term plus for most bond prices, it may have a positive effect over the shorter term. After all, by purchasing around 900 billion dollars worth of Treasuries, mostly intermediate maturity ones including the approximate $300 billion previously announced, the Fed is, in effect, increasing the demand side of the supply/demand equation. Thus, assuming supply remains constant, which is expected, this ordinarily would have the effect of raising the purchased bonds prices (and lowering long-term interest rates.) Indeed, Chairman Bernanke states that lower rates are a goal of QE.

But here is a conundrum: Another Fed goal is to raise inflation from near rock bottom levels. But is rising inflation consistent with a lowering of long-term bond yields? It appears that the only way for the two conditions to be so related is with a lag over time.

Normally, long-term bond yields move in the same direction as the rate of inflation. This suggests that if the Fed is successful in lowering interest rates over the shorter term, inflation may continue to be low until such time that the economy becomes stimulated to such an extent that inflation (and interest rates) do begin to rise. When might this happen (if it does happen at all)? No one, even the Fed, can profess to know the answer, but this would seem to require a drop in inflation first before it might eventually be able to go up, which might well take quite a while. How else can there be both a drop in long-term interest rates and a rise in inflation?

Planning a Course of Action

Like all investing decisions, we do not think one should weigh the value of one asset category in isolation. In other words, whether and how much to invest in bonds should also depend on the return potential in other types of investments. If any or all of the reasons given above persuade you to move money out of bonds, the question becomes "Will I clearly be better off in non-bond asset categories?" specifically either cash, stocks, or even hard assets such as commodities.

We would strongly argue, as we have done for quite a while, that cash simply does not appear to be a viable option. Returns on cash are likely to remain at no greater than 1% over the next few years as they have over the last 3 yrs. (Factoring in inflation, of course, means no return at all or even a negative return). The only way "investing" in cash makes sense is if you are sure (or, at least, very afraid) that other available investments will do even worse than 0!

We do believe that investors will be better off in stock investments than in bonds over the next few years. But suppose you currently have about a 60/40 stock/ bond fund allocation. Are you willing to carry your concern about bond potential underperformance far enough that you now simply take most or all of that 40% bond allocation and put it in stocks?

Except for either a) the most confident of investors, or perhaps b) relatively young investors who may have temporarily parked some money in bonds because of now greatly diminished fears of a double dip recession, we think that it is simply not justified to bolt out of most of one's bonds just because there may be a further trimming down of the formerly good returns lying ahead.

While bonds may lose some of their luster, it must be remembered that they will continue to provide an element of safety in an investment world that will remain far from certain.

As we have previously maintained, we expect the average bond fund to likely return an average of approximately 2.5 to 4.5% per year over the next several years. Stock funds, on the other hand, could according to our estimates, return on average about 6 to 8% per year. Given that no prediction can be counted on, and that there could be some higher bond returns or lower stock returns outside these ranges, we would recommend that moderate and conservative risk investors, especially those close to or in retirement, maintain a healthy commitment to bonds. We will update our recommended percentage allocations to stocks, bonds, and cash in our Jan. Newsletter.

Can a case be made for investing in commodity funds? Perhaps, but we generally tend to avoid such investments because they seem too volatile, unpredictable, and pay no dividends.