Wall Street's Best Minds
FRIDAY, APRIL 4, 2014
Rumor of Death of Bonds Greatly Exaggerated
By BRIAN REHLING
It will take more than a yield spike to get a mass rotation out of bonds, writes a Wells Fargo strategist.
After souring on fixed-income investments during the second half of 2013, investors are once again moving money into the asset class. The reported "great rotation" out of fixed income seems to have been short lived and not much of a rotation after all. We may still see the inflows into bonds reverse in the years ahead – but we believe that it will take a more meaningful event than a spike in yields or a year of negative returns to get investors to rotate out of the asset class in mass.
One catalyst that could exert sustained selling pressure on the fixed-income asset class, in our opinion, is an inflation scare. Inflation concerns do not appear to be a threat over the next couple of years and as a result, investors are likely to continue their flow into fixed income.
Fixed-income fund flows turned decidedly negative in May 2013. The change in investor sentiment was driven by a perception that the Federal Reserve was considering a change in monetary policy that could result in a slowing of bond purchases.
Although this was nothing more than a change in "sentiment," it nevertheless resulted in a sharp spike in interest rates. As an example, the yield on the 10-year Treasury rose 137 basis points (bps; note: 100 bps equals one percentage point) from May 1 to September 5, 2013; that 137 bps movement amounted to an 84% increase in yield, which was more than enough to shock investors, causing them to reduce their allocations to fixed-income funds.
Since September 2013, the interest rate environment has stabilized and higher interest rates are drawing back those investors who have put the past behind them. Since the beginning of this year, long-term fixed-income mutual fund flows have turned positive.
We expect that fixed-income mutual fund flows will remain positive over the course of 2014 as we anticipate only a modest orderly rise in interest rates for the remainder of the year. Looking forward, it is our expectation that the Fed will remain dovish even as growth increases and employment continues to fall.
Under such a scenario, interest rates are likely to rise over time but should remain well below normalized levels. Such policy may increase inflation over the long term, but we see little reason for investors to anticipate an inflation scare over the next couple of years. We expect investors to continue their flow into fixed income.
Considerations for managed product fixed-income investors
Investors that have chosen to purchase their fixed-income exposures through managed solutions have several factors they should consider.
A significant advantage of investing in ETF's and professional bond funds is that they can offer diversification over a broad range of issuers and sectors as well as offer professional management. Retail investors may also find that managing and rebalancing a fixed-income asset allocation will be more efficient due to better liquidity and price transparency than can be found in many individual fixed-income securities. Investors may not have adequate investment dollars to achieve this same diversification when purchasing individual bonds.
Many fixed-income managers have the ability to shorten the fund's duration to better position for rising rates. They may also have the ability to shift sector and security allocations in the interest of defending the portfolio against rising rates. The fund's prospectus will outline the portfolio manager's mandate and latitude in investing client's assets.
Investors should consider that most bond funds and fixed-income ETF's do not mature. As such, investors should be aware that in either an illiquid or rising interest rate environment (such as we experienced in June 2013), prices can fall and may not recover. Investors should consider that if prices begin to fall, there may be more investors redeeming their shares than buying. This can force the manager to sell bonds in the fund, into an often difficult market, in order to pay the investors that are redeeming shares. In addition, if no new money is flowing into the fund, the manager may not have as much cash to invest at higher rates. This dynamic can harm the performance of managed fixed-income solutions.
Returns and principal value of a mutual fund investment will fluctuate so that shares, when redeemed, may be worth more or less than their original cost.
Investors concerned about fixed-income price volatility and principal preservation should consider the purchase of high-quality individual fixed-income securities. Investors that purchase high-quality bonds have a relatively high likelihood of a stable income stream coupled with the return of principal as the security matures at par.
Fixed-income investors purchasing individual securities are exposed to market volatility, but with a high assurance of cash flow, investors may be able to look past fluctuations in market value to the value at maturity.
Investors should maintain a close eye on income needs and related liquidity. The risk of incurring substantial principal loss during a rising-rate environment is compounded by the potential need to liquidate certain holdings during these periods. If you're careful to match and adapt your spending needs with your income flows and have sufficient liquidity in cash reserves, other assets or available credit to help further avoid forced liquidations, you may be able to substantially reduce your potential realized principal loss associated with certain fixed-income securities.
Consider a bond ladder when purchasing individual securities. A bond ladder allows investors to systematically receive investable cash that can then be used to purchase new bonds (at potentially higher interest rates). Investors could realize losses in principal value should they sell positions before maturity.
Rehling is chief fixed-income strategist with Wells Fargo Advisors, the brokerage unit of Wells Fargo & Co.
One catalyst that could exert sustained selling pressure on the fixed-income asset class, in our opinion, is an inflation scare. Inflation concerns do not appear to be a threat over the next couple of years and as a result, investors are likely to continue their flow into fixed income.
Fixed-income fund flows turned decidedly negative in May 2013. The change in investor sentiment was driven by a perception that the Federal Reserve was considering a change in monetary policy that could result in a slowing of bond purchases.
Although this was nothing more than a change in "sentiment," it nevertheless resulted in a sharp spike in interest rates. As an example, the yield on the 10-year Treasury rose 137 basis points (bps; note: 100 bps equals one percentage point) from May 1 to September 5, 2013; that 137 bps movement amounted to an 84% increase in yield, which was more than enough to shock investors, causing them to reduce their allocations to fixed-income funds.
Since September 2013, the interest rate environment has stabilized and higher interest rates are drawing back those investors who have put the past behind them. Since the beginning of this year, long-term fixed-income mutual fund flows have turned positive.
We expect that fixed-income mutual fund flows will remain positive over the course of 2014 as we anticipate only a modest orderly rise in interest rates for the remainder of the year. Looking forward, it is our expectation that the Fed will remain dovish even as growth increases and employment continues to fall.
Under such a scenario, interest rates are likely to rise over time but should remain well below normalized levels. Such policy may increase inflation over the long term, but we see little reason for investors to anticipate an inflation scare over the next couple of years. We expect investors to continue their flow into fixed income.
Considerations for managed product fixed-income investors
Investors that have chosen to purchase their fixed-income exposures through managed solutions have several factors they should consider.
A significant advantage of investing in ETF's and professional bond funds is that they can offer diversification over a broad range of issuers and sectors as well as offer professional management. Retail investors may also find that managing and rebalancing a fixed-income asset allocation will be more efficient due to better liquidity and price transparency than can be found in many individual fixed-income securities. Investors may not have adequate investment dollars to achieve this same diversification when purchasing individual bonds.
Many fixed-income managers have the ability to shorten the fund's duration to better position for rising rates. They may also have the ability to shift sector and security allocations in the interest of defending the portfolio against rising rates. The fund's prospectus will outline the portfolio manager's mandate and latitude in investing client's assets.
Investors should consider that most bond funds and fixed-income ETF's do not mature. As such, investors should be aware that in either an illiquid or rising interest rate environment (such as we experienced in June 2013), prices can fall and may not recover. Investors should consider that if prices begin to fall, there may be more investors redeeming their shares than buying. This can force the manager to sell bonds in the fund, into an often difficult market, in order to pay the investors that are redeeming shares. In addition, if no new money is flowing into the fund, the manager may not have as much cash to invest at higher rates. This dynamic can harm the performance of managed fixed-income solutions.
Returns and principal value of a mutual fund investment will fluctuate so that shares, when redeemed, may be worth more or less than their original cost.
Investors concerned about fixed-income price volatility and principal preservation should consider the purchase of high-quality individual fixed-income securities. Investors that purchase high-quality bonds have a relatively high likelihood of a stable income stream coupled with the return of principal as the security matures at par.
Fixed-income investors purchasing individual securities are exposed to market volatility, but with a high assurance of cash flow, investors may be able to look past fluctuations in market value to the value at maturity.
Investors should maintain a close eye on income needs and related liquidity. The risk of incurring substantial principal loss during a rising-rate environment is compounded by the potential need to liquidate certain holdings during these periods. If you're careful to match and adapt your spending needs with your income flows and have sufficient liquidity in cash reserves, other assets or available credit to help further avoid forced liquidations, you may be able to substantially reduce your potential realized principal loss associated with certain fixed-income securities.
Consider a bond ladder when purchasing individual securities. A bond ladder allows investors to systematically receive investable cash that can then be used to purchase new bonds (at potentially higher interest rates). Investors could realize losses in principal value should they sell positions before maturity.
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