Federal Reserves Board Chairman Ben S. Bernanke may be doing everything he can to push investors out of U.S. Treasuries and into riskier assets, but so far, mutual fund investors aren't buying into the idea.
Bond funds — particularly taxable-bond funds — continue to be the investment of choice for mutual fund investors. Another $78.5 billion poured into such funds in the first quarter, despite the fact that the 10-year Treasury note is yielding less than 2%.
Assets in such funds have more than doubled since the end of 2008 to more than $2.1 trillion, and the segment's share of overall mutual fund assets grew to 25%, from 20.6%, during that period, according to data from Morningstar Inc.
In the same period, about $200 billion more flowed out of U.S. stock funds than was invested, despite the S&P 500's returning about three times as much as the Barclays Capital U.S. Aggregate Bond Index, the major benchmark for bond fund managers.
"NO PRECEDENT'
“We've never seen numbers like this before. There's no precedent for it,” said Eric Jacobsen, director of fixed-income research at Morningstar.
“It's a question of how far people are willing to tilt their portfolios based on fear, rather than long-term asset allocation,” he said.
Pretty far, it appears. However, with real yields on the 10-year Treasury note now negative, bond fund managers are girding themselves for a rise in interest rates.
“I think it's the end of the bull market in bonds,” said Dan Fuss, vice chairman of Loomis Sayles & Co. LP and manager of the $21.2 billion Loomis Sayles Bond Fund (LSBDX). “I don't think it's going to be a spike-type ending, but it's reasonable to assume that we're at the beginning of a secular rise in interest rates.”
That was a reasonable assumption at the beginning of last year, too, but the 10-year Treasury note ended up returning 16.04% for investors.
Like many fixed-income managers, however, Mr. Fuss is operating under the assumption that the United States will not experience a scenario akin to that in Japan, where historically low interest rates continue to go lower. Over the past year, he has shortened the average maturity of his portfolio to 10 years, from 19, and is taking on more credit risk — as opposed to interest rate risk.
“Our correlation with the bond market is now low,” Mr. Fuss said.
“People are going to shift their investment to equities and real estate,” he said. “It just hasn't happened yet.”
HERD MENTALITY
As a group, bond fund managers are of the same mind.
The correlations of intermediate-term-bond funds, the biggest segment of the industry, with the Barclays benchmark have dropped precipitously since the financial crisis. The early move out of Treasuries by Bill Gross, co-founder and co-chief investment officer of Pacific Investment Management Co. LLC and portfolio manager of Pimco's Total Return Fund (PTTRX), is the most notable example.
However, the sector's overall correlation to the index fell to about 62 at the end of February, from more than 90 at the end of 2008, according to Mr. Jacobson.
Managers are allocating more money to high-yield bonds, non-U.S. developed-market debt and emerging-markets debt, non-agency mortgage securities and even municipal bonds. Last year, that hurt their returns relative to the index.
Between the Japanese tsunami, political unrest in the Middle East, the U.S. credit downgrade and the European debt crisis, the market repeatedly retreated to the safety of U.S. Treasuries despite the paltry yields and the increasingly ugly financial condition of the U.S. Just 12% of managers of intermediate bond funds outperformed the Barclays index last year.
Nevertheless, Jeff Rosenberg, chief investment strategist for fixed income at BlackRock Inc., said that investors have to break their old habits.
“With the backdrop of declining interest rates over the last 30 years, investors learned to think of bonds as an alternative form of capital appreciation,” he said. “As we look forward, however, we can't expect that capital appreciation in funds where we've seen it in the past.”
NEGATIVE YIELDS?
Investors also can't expect much income with 10-year Treasury rates back below 2%, or even preservation of capital, given the more than 2% to 3% rate of inflation. Mr. Rosenberg is expecting a 50- to 75-basis-point rise in the yield of the 10-year Treasury note to between 2.5% and 2.75% by year-end.
A move in rates of even such a modest proportion would result in negative yields on most intermediate-bond funds closely tracking the Barclays index.
If fixed-income investors want to avoid the erosion of their capital, they need to reduce interest rate risk and take on more credit risk.
“In the new fixed-income world, risk-free assets don't allow you to preserve real capital,” said Mr. Rosenberg, whose firm actively manages $620 billion in fixed-income assets. “The only solution is [to] take on more investment risk.”
To lower his interest rate risk, Mr. Rosenberg is reducing his already “minimal exposure” to Treasuries and opting for Treasury inflation-protected securities.
High-yield bonds are a good place to look for more yield, he said.
Mr. Rosenberg expects a 7% to 8% return on high-yield bonds as an investment category this year, with 90% of that return coming from the coupon rate.
CREDIT RISK
He also favors muni bonds, with the caveat being that investors must consider the credit risk of specific issuers much more carefully. Most new muni issues don't carry bond insurance, and the credit profiles of issuers have deteriorated significantly.
However, the average yield on munis is now between 100% and 120% of that of Treasuries of comparable duration — even before the tax benefits. They will suffer if and when interest rates rise, but the extra yield can cushion the blow.
“Investors have to go in open-eyed,” Mr. Rosenberg said. “The yield benefits come with more risk, and how those risks will be mitigated over the next two years is critical.”
Charles Zhang, head of Zhang Financial, a registered investment adviser affiliated with LPL Financial LLC, doesn't think that stretching for additional risk in the fixed-income market is worthwhile.
For clients who demand “safe, conservative” investments, he sticks with short-term global bond funds — preferably those with low expense ratios, such as those from Dimensional Fund Advisors LP or The Vanguard Group Inc.
For risk, Mr. Zhang said he will look elsewhere.
“Interest rates are going to go up. It's just a matter of time,” he said. “If I'm going to take on risk, I'd rather be in the stock market.”
Mr. Bernanke would approve.
aosterland@investmentnews.com
