Funds, ETFs hold up in quarter, but bulls face new challenges
March 30, 2012, 12:01 a.m. EDT
Article from Market Watch
By Rachel Koning Beals
March 30, 2012, 12:01 a.m. EDT
Article from Market Watch
By Rachel Koning Beals
CHICAGO (MarketWatch) – Is it possible to smoothly downshift this 30-year bond bull run?
Most bond investing experts claim yes, with a proviso: the easy ride hinges on buyers coming to terms with lower returns and rethinking what it means to take risk.
“You can no longer think of Treasurys as an investment, but only a safe-haven,” said Paul Nolte, managing director of investment manager Dearborn Partners. “We’ll probably know a lot more in four to six weeks but if the economy continues to look pretty good, you just have to venture into corporate bonds [or] emerging markets for any hope at investment returns.”
If the first quarter is any indicator, bond market behavior may finally reflect the “new normal” that Pimco’s Bill Gross and others first started talking about a few years back. In the first three months of 2012, long-dated government debt funds fell 5.5%, according to preliminary data from investment researcher Morningstar Inc. Shorter-term government funds were essentially flat.
So far this year, economic data has perked up and stocks posted solid gains. Bonds assumed an expected role, reflecting the “risk-on” approach. Emerging-market bond funds led all categories, with a 7% gain through March 28, according to Morningstar. High-yield bond funds were up 5.5% in the period, while higher-rated multi-sector corporate debt funds were up 4.1%. World bond funds rose 2.2%. In the tax-exempt space, national long-dated muni bond funds rose 2.9%, while high-yield muni funds gained 4.7%.
But the bond market has been fooled before. Each of the past two years started with outperformance of corporates and other higher-yielding areas, including stocks, only to see “investors run for the hills” and the relative safety of Treasurys in the middle of the year before a late-year scamper back to risk, Nolte said. On more than one occasion, lower-risk bond fund returns looked ready to crack and yet each quarter, they defied even expert expectations.
Stay in the lane
Is it different this time? Fund managers steered through the 2008 credit crisis and the still-lingering European debt malaise. Now, a slowing Chinese economy, spotty-if-improving U.S. growth and a volatile oil-price scenario raise concerns for the viability of riskier fixed-income categories. That includes lower-rated company debt and international bonds.
The Fed has pegged short-term rates at ultra-low levels and it’s buying longer-term paper to push down mortgage rates, but that program will run out in coming months.
In its attempt to stay a step ahead of the Fed, the bond market sold off in the early year. Treasury prices fell perhaps a little too fast. Falling prices push up yields as the market was pricing in higher future interest rates.
As the “new normal” camp made its case in recent years and again to start 2012, fund managers got a boost of confidence in their view from none other than Federal Reserve chief Ben Bernanke. He stepped in with an ABC evening news appearance and delivered a renewed pledge for low rates until late 2014. The market correction paused.
While Bernanke took to the airwaves, Rick Rieder, BlackRock’s chief investment officer of fixed income, fundamental portfolios, penned a column for The Financial Times to boost the bond bulls’ case:
“We have all heard the bears’ case for bonds: with governments and consumers in the developed world drowning in debt and negative real interest rates on many sovereign bonds, yields can only rise — quickly,” he wrote. “Not so fast: The confluence of profound supply and demand factors, with a dash of monetary policy distortion thrown in, will ensure bonds remain well-bid — and interest rates capped — for years to come.”
The reason? Supply, for starters. The U.S. bond market is smaller since the financial crisis. And, banks are issuing fewer bonds as they deleverage and cut risk under new regulations. Demand is another factor. Pension funds will remain buyers and will want a deeper bond mix to boost yield.
Rieder, who oversees some $615 billion in assets, ventures the only “bubble” in the bond market appears to be the “overinflated talk of bond market bubbles in recent years.”
Pick your spots
The fixed-income world’s guarded confidence hinges on the fact most tossed out the manual a while ago, no longer expecting bonds to behave a certain way and stocks to assume the counter position for a reasonable amount of time. Targeted domestic bond investing in search of yield, yet mindful of duration risk and credit quality, and a preference for emerging market paper over sovereign issuance are strategies that have paid off and may continue to do so.
“There’s an interesting dichotomy at work,” said Paul Matlack, U.S. fixed-income strategist with Delaware Investments. “The economic recovery may be touch-and-go but U.S. corporations are in the best shape they’ve been in for years.”
“Companies really cut to the bone, in fact probably over-fired in 2008 and shuttered plants. Now, profitability has skyrocketed. They’re refinancing debt. Large companies now have tremendous access to bank capital and the debt markets,” he said.
Morgan Stanley Smith Barney is taking a tactical approach. The firm’s analysts believe that developed-market central-bank policy rates are likely to remain low for years, a third round of Fed Quantitative Easing could be likely later this spring, and that the European Central Bank’s QE equivalent has been a success.
Meanwhile, a few emerging market central banks have already begun easing to offset slower developed-market growth. The firm is overweight cash, short-duration bonds, investment grade bonds and managed futures. It suggests an underweight to developed-country sovereign debt, high yield bonds, equities, commodities, global real estate investment trusts and inflation-linked securities. Emerging-market bonds receive a market-weight.
Pimco favors high quality, shorter duration and inflation-protected bonds; dividend paying stocks with a preference for developing over developed markets; and inflation-sensitive, supply-constrained commodity products.
Once again managers are hopeful they won’t yet have to toss out the “new normal” label — ultra-low overall rates and improved corporate conditions. The bigger challenge appears to be conditioning investors to think about bonds differently than they have for decades.
Gross put it this way in his latest commentary: “Total return as a supercharged bond strategy is fading ... As we delever, it will be hard to deliver what you have been used to. Should you desert bonds simply because they may return 4% as opposed to 10%? I hope not.”
Rachel Koning Beals is a Chicago-based freelance writer.
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