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Investors Exit Bond Funds

Preparing for Stimulus Reduction

Written by Joseph Cafariello
Posted July 2, 2013 at 1:58PM

For some time, analysts had been dumbfounded by the continued flows into bonds and bond funds, chasing miserable yields with ever-increasing risks of a meltdown, especially in the face of a stellar equities market.

It took only one speech, one paragraph, one phrase to finally swing open the gates… U.S. Federal Reserve Chairman Ben Bernanke’s fateful words: “letting up a bit on the gas pedal”. The Fed is preparing to begin reducing its monthly bond purchasing program.

bernankeWith that, the bond exodus has begun! And in spectacular form too, as David Santschi of TrimTabs noted in a recent report cited by CNBC:

“The herd is scrambling for the exit this month as bond yields back up across the board and central bankers hint that they might provide less monetary stimulus in the future. We estimate that bond mutual funds have lost $70.8 billion in June through Thursday, June 27, while bond exchange-traded funds have lost $9.0 billion.”

But bond experts including PIMCO’s Bill Gross are advising investors to calm down; the flight from bonds “is overdone”.

Have you decided which way to go? Stay aboard or abandon ship? We will first need to look out over the waters at what is approaching.

Assessing the Situation

As we look around, we make three key observations:

1.) Stimulus days are numbered

Now we all knew stimulus wouldn’t last forever and sooner or later the Federal Reserve would stop tossing free money at the economy.

We also know that shortly after the monthly bond purchasing program terminates, interest rates will slowly begin their rise back to normalization.

This is the iceberg that will sink the bond ship – higher interest. It is still a way off, but it’s coming.

2.) Not going into equities

Another observation we make is that the bulk of the recent bond outflows has not been going into equities. As of last week, only $400 million (less than 1% of June’s bond outflows leading up to the 24th) has gone into equities, TrimTabs’ research shows.

“That money is not going to stocks,” MarketWatch cites Santschi’s report. “It’s going into bank products and money-market funds, even if investors don’t think they will get any real return there.”

Investors, it seems, are expecting a correction in both markets – bonds and equities alike. It’s quite understandable, given that Fed stimulus had inflated both markets equally. Any reduction of stimulus would therefore deflate them both.

Investors are thus fleeing to the safety of cash.

3.) Shifts within the bond spectrum

The final key observation we make is that not all bonds are reacting the same to the exodus. There is something of a rotation within the bond market, as can be seen by comparing two bond categories:

  • iShares 1-3 Year Credit Bond ETF (NYSE: CSJ)

Percent change: 12 mo = +0.5%, 6 mo = -0.5%, 3 mo = -0.5%, 1 mo = -0.5%

  • iShares 10+ Year Credit Bond ETF (NYSE: CLY)

Percent change: 12 mo = -7.9%, 6 mo = -10%, 3 mo = -6.8%, 1 mo = -4.7%

The rotation within the bond space is duration driven. In the approaching stimulus tightening environment, shorter term holdings will earn more interest compared to longer term instruments.

Piecing together all three observations, we can conclude interest rates will soon be on the rise, and those in-the-know are switching from long term bonds and funds to shorter termed ones, though fleeing to cash in the immediate term.

What to Expect Going Forward

But even the Titanic took the whole night to go under after it was struck. Government Treasuries and corporate bonds can likewise remain afloat for a little bit longer, prompting PIMCO’s Bill Gross – revered by the bond industry as “Mr. Bond” – to caution bond investors not to panic:

“Without the presence of a ‘Bernanke Put’ or the promise of a continuing program of QE check writing, almost all of them had too much risk,” he admonished in a letter to investors obtained by CNBC. “Investors found the [bond] lifeboats dysfunctional ... This is overdone.”

Treasuries just need to find their adjusted waterline in the aftermath of the recent Federal Reserve communiqués.

As Erik Nielsen, chief global economist at UniCredit, indicated to CNBC, “People are sort of finding the normal level of risk again.” He expects this adjusted level of risk in the U.S. 10-Year Treasury yield to sit at around the 3% mark.

In the meantime, however, “in the process of going to 3% [people] will leave,” Nielsen expects. “They will [want] to own it when it gets to 3.5%. But the process [of going from 2.5 to 3.5] implies capital losses, and you wouldn't want to sit on those losses if you can avoid it.”

So while the bond market adjusts to the Fed’s new direction, bond investors are staying clear… of everything. If bonds are going to correct down to a new level, we could expect equities to do the same – a process which could take the remainder of the summer.

But once the markets find those new risk levels and watermarks that are more in-line with the Fed’s new plans, we could expect a reversal out of cash and money-markets back into then higher yielding Treasuries and lower-valuated equities.

Prepare for the Sinking

Any return to bonds after this pullback settles, though, will be futile. The bond ship that kept aloft so well during stimulus will go down when rates rise.

The smart money has already given us a sign of where to flee: shorter term duration variable rate bond funds will be the preferred choice over anything long term and fixed. But let’s not forget the banks and Business Development Corporations, who will also enjoy increased profits from higher interest rates.

The graph below compares June’s activity for a selection of stocks and funds from across the bond and corporate lending sector, including:

  • U.S. 10-Year Treasury
  • New York Community Bancorp (NYSE: NYCB) = June +7.6%; div yield 7.08%
  • Nuveen Floating Rate Income Opp. Fund (NYSE: JRO) = June +1.8%; div yield 6.72%
  • Fifth Street Finance Corp (NASDAQ: FSC) = June +0.7%; div yield 10.91%
  • iShares Barclays 1-3 Year Credit Bond ETF (NYSE: CSJ) = June -0.5%; div yield 1.2%
  • SPDR Barclays High Yield Bond ETF (NYSE: JNK) = June -2.1%; div yield 6.21%
  • iShares 10+ Year Credit Bond (NYSE: CLY) = June -4.7%; div yield 4.98%

june bond activity 7-2-13 small(click to enlarge) Source:

The “% Compare” window at the bottom of the graph compares all stocks to the 10-Year’s yield, which is flatlined in black. As the Treasury yield rose during week 3, all of these selected stocks fell; vice-versa during week 4.

Yet the stocks fan out according to an interesting pattern – a pattern we will be seeing more of leading up to rate normalization. The worst performers were CLY and JNK, bond funds with long term durations and locked interest rates. In the middle were the short duration bond fund CSJ and business development corporation FSC, while the best performers were the variable rate bond fund JRO and the regional bank NYCB.

It may still be early to transition entirely, as the Fed’s plans of stimulus reduction have not even begun to be implemented yet. But the big money is clearly making a transition now. This summer may very likely provide us with great opportunities to buy on the dips and snag ourselves some even heftier dividend yields.

Risks of Holding Until Maturity

There is one last point to note about individual bonds versus bond funds. If you paid cash for bonds and intend to hold them to maturity, you will not be adversely affected by lower bond prices during sell-offs.

Indeed, the value of your bonds will fall. But at maturity you will get your principle back plus earned interest, barring any defaults, of course.

Bond investors who hold to maturity, therefore, need not worry over falling bond prices as much as bond traders do.

However, if your bonds are of long duration, you now have to compare what you will be earning from them to what you could be earning from any new bonds at today’s lower prices and higher yield. Too much hassle? This is why many would rather let the bond funds handle that.

You must decide how to best navigate the frigid waters our markets find themselves in. Remember the new bond pattern just now beginning to emerge, where short durations are preferred over longer ones, and variable rates are preferred over locked ones.

We are witnessing the changing of the bond guard – the demotion of one and the promotion of another – that will likely remain in place for the next 5 years or more.

Joseph Cafariello


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