Bond market awaits tapering with bated breath

With the Federal Reserve expected to start reducing its five-plus-year quantitative-easing program as early as next month, the bond market can only wait and hope that investors maintain a sense of calm as the tapering approaches. “The idea that the ending of quantitative easing will mean there's no buyers for debt and that yields will go to the moon is flawed logic,” said Matt Duch, a fixed-income portfolio manager at Calvert Investments Inc. “I think retail investors are becoming more sophisticated and asking more intelligent questions with regard to bonds,” he said. “But I don't really know how investors will react when the tapering actually begins.” As Fed Chairman Ben S. Bernanke made clear more than a month ago, the central bank is likely to start reducing its $85 billion monthly pace of Treasury bond buying by between $10 billion and $20 billion next month. For fixed-income wonks, the 12-month tapering process that will effectively take a major bond buyer out of the market isn't the biggest challenge because it is generally believed that the incredible efficiency of the bond market has already priced in the upcoming tapering process. The wild card is the reaction — and potential overreaction — from retail investors. “We saw retail investors sell out of bonds in June when Bernanke announced plans to start tapering, and that kind of selling could happen again when tapering begins,” said Michael Collins, manager of the Prudential Total Return Bond Fund (PDBAX). “You could get another panic like you had in June, and you could see the 10-year Treasury yield go to 3.25% over the next 12 months,” Mr. Collins said. “It definitely concerns us, and it's something we're very focused on, but we would look at it as a buying opportunity.” One reason that pros such as Mr. Collins would view any sudden spike in yields related to tapering as a buying opportunity is because the bond market is known for quickly pricing in future Fed activity. But retail investors? Not so much. Bond mutual funds had more than $60 billion worth of net outflows in June after Mr. Bernanke laid out the Fed's plans to reduce the bond-buying program. June's net outflows from bond funds, which were followed by five consecutive weeks of net outflows, marked the first full month of net outflows from bond mutual funds since August 2011. Mr. Collins said that he wouldn't be surprised to see some investors exiting bond funds once the tapering actually begins, but that kind of reaction would be well behind the curve. “If you just looked at the bond markets during each of the last three rounds of quantitative easing, you saw that the markets rallied and yields bottomed before the Fed started buying any bonds,” he said. “And by the time they started buying the bonds, the markets were already selling off.” The yield on the closely watched 10-year Treasury bond hit its most recent low point of 1.38% last summer and is now hovering around 2.6%, suggesting to Mr. Collins that the bond market is already positioned for the tapering process. “The yield curve has gotten really steep, meaning there's a lot of Fed funds rate already priced in,” he said. “You're already getting paid for higher rates.” Scott Colyer, chief executive and chief investment officer at Advisors Asset Management Inc., has a slightly different take on the outlook for bonds in a tapering scenario. “Generally speaking, you can only surprise the market one time, so tapering probably won't have as much of an impact as will the association with inflation,” he said. “We think the tapering will indicate to the rest of the market that inflation expectations are rising, and once inflation begins, it won't be easy to stop.” Mr. Colyer's biggest concern is the snowball effect that a spike in interest rates could trigger, with or without any actions from the Fed. “At the end of the day, chances are, you're going to see higher rates, and we think the market will lead the Fed,” he said. “We think this is a secular change in bond prices, because investors that hold fixed income are very risk-averse; that's why they hold them,” Mr. Collins said. “And we already saw in June how close investors' fingers are to the sell button.”