Fear rising with rates; Bond market sell-off likely a question of when, not if, and investors ‘have no idea what’s about to happen’; Bond bomb survival guide; New investment strategies that are intended to thrive in a rising-rate environment are fast emerging

Fear rising with rates

Bond market sell-off likely a question of when, not if, and investors ‘have no idea what’s about to happen’

By Andrew Osterland

Mar 10, 2013 @ 12:01 am (Updated 4:58 pm) EST

Fear among financial advisers of a bond market crash that could devastate the portfolios of millions of investors is growing amid improving economic news and rising U.S. bond yields.

The yield on the 10-year U.S. Treasury note is climbing after hitting an all-time low of 1.43% last July. As bond prices move in the opposite direction of yields, the rise in market yields could spell huge losses for investors — especially for those in bond mutual funds, where portfolio managers would be forced to sell their holdings at a loss to meet redemption demands.

Over much of the past three decades, falling interest rates have fueled a rally in the bond market. In the years following the 2008-09 financial crisis, investors — lured by the perceived safety of bonds — poured billions of dollars in retirement and other assets into bond funds.

In 2012, for example, net inflows into bond funds totaled $304 billion, compared with outflows of $153 billion for stock funds. Investors’ enduring appetite for bonds is particularly striking in light of the fact that the Barclays U.S. Aggregate Bond Index gained 4.2% in 2012, versus the S&P 500’s 16% advance.

Over the past five years, net inflows into bond funds topped $1 trillion, while outflows from stock funds totaled $421 billion, according to the Investment Company Institute.


For many, if not most, it’s a question of when the bond market sells off — not if.

“Bonds are a big problem, and most people don’t understand that yet,” said Harry Clark, chief executive of Clark Capital Management Inc. “The public thinks bonds are safe, but they’re not. They have no idea what’s about to happen to them.”

If nothing else, investors in bonds are going to have to get used to more volatility. With yields so low and interest rates starting to rise, bond prices are likely to move far more dramatically than they have in the past.

“Normally, people don’t think of Treasuries as riskier than equities, but 30-year Treasuries are now more volatile than equities are,” said Rick Reider, chief investment officer of fixed income at BlackRock Inc.

“Buyer beware. There’s a big yellow sign saying, “Caution ahead.’ It’s not going to be pleasant when rates go up,” said David Sherman, president of Cohanzick Management LLC, which manages a high-yield-bond fund.

The brokerage industry’s chief regulator agrees. Last month, the Financial Industry Regulatory Authority Inc. took the unusual step of issuing an investor alert about the vulnerability of bonds and bond funds.

“Many economists believe that interest rates are not likely to get much lower and will eventually rise. If that is true, then outstanding bonds, particularly those with a low interest rate and high duration, may experience significant price drops as interest rates rise along the way,” Finra warned.


The turn in the market may have begun already.

The yield on the 10-year Treasury bond, just under 2%, is up more than 35% from the record low in July. Investors are almost certainly going to see negative real returns on their Treasury portfolios in the first quarter — a rare event that many feel has the potential to trigger a wider sell-off in the market.

“Once investors feel the pain from interest rates rising, it could be a catalyst for further selling,” said Scott Colyer, chief executive of Advisors Asset Management Inc., which acts as a subadviser for many investment advisers.

Financial advisers, for their part, are uncertain about how to react to a capitulating bond market.

A recent survey of more than 300 financial advisers by InvestmentNews found that the average client allocation to fixed income of more than half the respondents is between 31% and 50%.

Fifty-one percent of respondents expect interest rates to increase this year, while 47% believe they will stay at the same level. A majority of advisers (57%) said they intend to advise clients to decrease their fixed-income allocations this year, while 40% will recommend keeping current allocations the same.

“They know there’s a problem but don’t how to attack it,” said Mr. Colyer, referring to how advisers are thinking about the bond market.

With the Federal Reserve keeping short-term rates near zero and long-term rates near historic lows with its bond-buying program, there’s little room for further price appreciation. That means unless the U.S. economy hits the skids — a scenario that is looking increasingly unlikely — interest rates have nowhere to go but up.

A rapid rise in interest rates would bludgeon many existing bond portfolios. Simple bond math holds that a 1-percentage-point rise in interest rates would result in a roughly 1% decline in prices for every year of a bond’s duration.

“A 15-basis-point jump in rates will wipe out annual yields now, and we could get that in a week,” said Mr. Reider, who nevertheless expects low rates and low inflation for several years.

Mark Sear, chief executive of advisory firm Luminous Capital LLC, is maintaining a 35% allocation to fixed income, with about half of that in a municipal bond ladder. He favors mortgage-backed securities and non-dollar debt to U.S. government bonds, high-quality corporate debt and high-yield bonds, which are now yielding, on average, below 7%.

“I see a slow migration of rates higher, but yields are so low that you can end up making nothing on your fixed income,” Mr. Sear said. “There are still ways to make money in fixed income, but it’s not going to be like last year.”

Chris Wolfe, chief investment officer for the private-banking group at Bank of America Merrill Lynch, thinks that the conditions are right for a rotation from bonds into stocks, but he, too, doesn’t see a rapid rise in rates in the near future.

Mr. Wolfe expects the Federal Reserve to continue to focus on bringing unemployment down to 6.5% before it changes its ultra-accommodative monetary policy — despite recent reservations expressed by some Fed governors about the QE3 bond-buying program.


Mr. Wolfe, who has been shortening duration and increasing credit risk in his fixed-income allocations, also thinks that baby boomer demographics are likely to preclude a massive shift out of bonds by investors.

“The demand for income and yield is unabated,” he said. “As long as inflation remains modest, people will look to bonds for income.”

That income is thin, and while rates are rising, bonds no longer may be the safe investment that they have been for most of investors’ lifetimes.

“I don’t think the market is going to blow up next week, but you have to plan for a potential shock,” Mr. Colyer said. “It’s time to play defense with bond portfolios.”

Bond bomb survival guide

New investment strategies that are intended to thrive in a rising-rate environment are fast emerging

By Jeff Benjamin

Mar 10, 2013 @ 12:01 am (Updated 4:57 pm) EST

Get ready for a new era in fixed-income investing. Whether or not the 30-year bull market in bonds goes out in a blaze of glory tomorrow, new investment strategies that are intended to thrive in a rising-rate environment are fast emerging. For many investors and advisers, their debut comes not a moment too soon.

“The opportunity to take advantage of falling interest rates in a bond fund is pretty much done,” said J. Brent Burns, president of Asset Dedication LLC, which builds fixed-income separate accounts. “It’s been a fantastic ride in bond funds, but now advisers need to be looking for ways to protect principal.”

One way is to invest in nontraditional, or “go anywhere,” bond funds. These funds, the majority of which burst on the scene after the 2008-09 financial meltdown, are completely unconstrained by credit quality, geography and maturities.

“We are seeing a lot more funds come out with broader mandates and that includes things like more flexibility on the duration of the bonds they own,” said Sarah Bush, a Morningstar Inc. fund analyst.


Of the 51 such funds tracked by Morningstar, which represent $66 billion in assets, 32 have been launched since 2009.

“The nontraditional category really points to the way fund companies are looking for different ways to structure products,” Ms. Bush said. “Reflecting concerns about relative value, they’re moving away from core bond funds in favor of lighter Treasury stakes, and taking on more corporate and mortgage risk.”

Even strategies that are not considered alternative are scrambling with short-duration defensive moves and all manner of flexibility.

“The bond market right now is different than it has ever been, because this is the first time in 30 years when there is no yield in the investment-grade market,” said Paul Lefurgey, managing director at Madison Investment Advisors LLC, which has $16 billion in assets under management, in-cluding $9 billion in bond strategies.

In the Madison Mosaic Institutional Bond Fund (MIIBX), interest rate exposure has been reduced to about half that of the market, and active management has become the rule, Mr. Lefurgey said.

“We’re an active manager, similar to a stock fund manager,” he said. “And we’re willing to deviate from the market.”


While nobody is suggesting that core bond funds are racing toward extinction, investors and advisers need to alter their fixed-income expectations, experts contend.

Jeff Rosenberg, chief investment strategist at BlackRock Inc., suggests that bond investing is splitting into three distinct subcategories: income, appreciation and preservation.

“As advisers and investors, you have to choose which one of the three is most important, but you can’t do all three at the same time anymore,” he said.

Further, Mr. Rosenberg points out, some subcategories of fixed income don’t even involve bonds. Dividend-stock investing, for example, is growing in popularity as an alternative income strategy.

Even traditional bond ladders, which offer predictable income and a certain level of security when bonds are held to maturity, are getting swept up in the changes.

In 2010, Guggenheim Investments Inc. launched BulletShares Corporate Bond ETFs as a series of target maturity bond ETFs that mature on a specific date, just like a bond.

“We saw an opportunity because holding bonds to maturity protects from interest rate risk, but there are challenges to buying individual bonds,” said Bill Belden, Guggenheim’s head of product development.

While BulletShares ETFs are designed to work like individual bonds as part of staggered bond portfolio, Mr. Belden said Guggenheim has had to spend a lot of time educating advisers on how they can best be used in a portfolio.

“The BulletShare ETF is not a strategy, it’s a component of a strategy,” he said. “I think the thing advisers like about a bond fund is that it is a complete strategy.”

BulletShares have attracted approximately $2 billion in assets and spawned at least one clone. BlackRock’s ETF arm has a similar target-maturity-bond product in registration that is expected to launch this spring.

The rollout of target-maturity ETFs by firms such as BlackRock and Guggenheim adds a fresh endorsement to the traditional bond-ladder strategy as a means of protecting principal.

Regardless of an investor’s fixed-income objectives, the onus will be on financial advisers to help steer clients through the next cycle for bonds.

“Given how fluid the world is today, and given the influence of politics and unusual central bank policies, we think it is important for financial advisers to conduct scenario analyses with their clients in the context of a solution mindset rather than the traditional product one,” said Mohamed El-Erian, chief executive and co-chief investment officer of Pacific Investment Management Co. LLC.

“The bond market offers you different mixes of liquidity, term, credit, currency and interest rate exposure, and the key for any investor is to understand where they stand in this mix and how it is likely to behave under different market conditions,” he said. “The important reality to remember is that the global bond market is far from homogeneous.”

ETFs offer no haven during a stampede

Exchange-traded funds’ liquidity could be a double-edged sword

By Jason Kephart

Mar 10, 2013 @ 12:01 am (Updated 4:36 pm) EST

Investors looking for a low-cost and liquid way to access the fixed-income market have been piling into exchange-traded-bond funds, but experts urge caution.

Bond ETF users tout the ease with which they can get into and out of bond markets as the top reason for using the products.

In fact, more than 70% of financial advisers cited liquidity as the biggest advantage that bond ETFs have over individual bonds or bond mutual funds, according to a survey by Guggenheim Investments last fall. Just 16% cited lower costs.

But that liquidity could be a double-edged sword, said Todd Rosenbluth, director of ETF research at S&P Capital IQ.

Fixed-income ETFs are only as liquid as their underlying bonds. Once investors start moving out the bond spectrum into more-illiquid securities such as high-yield bonds and municipal bonds, the ETF’s share price can dislocate from its net asset value in times of extreme inflows or outflows.

When the ETFs are experiencing large inflows, they tend to trade at a premium, which means that investors are buying $1 worth of bonds for slightly more than that, and during outflows, they trade at a discount, meaning that investors who are leaving aren’t getting their full $1 of NAV back.

The $15 billion iShares iBoxx High Yield Corporate Bond ETF (HYG), the largest high-yield-bond ETF, has seen its share price veer as far as 2.88% ahead of its NAV and 1.76% below, according to Morningstar Inc.

This, however, allows advisers to see where the ETF is trading relative to its NAV before making a trade, so if they aren’t following the crowd, they can use it to their advantage.

“It’s all about awareness,” Mr. Rosenbluth said.

Assets in fixed-income ETFs, while still dwarfed by those of mutual funds, have more than quadrupled to $255 billion, from $56 billion at the end of 2008, making them the fastest-growing bond investment over the past four years. Meanwhile, bond mutual fund assets have doubled to more than $2 trillion.

Q&A with Bill Gross: Making a case for bonds, even as returns falter

The Pimco chief discusses his outlook on bonds, interest rates and why the so-called great rotation out of bonds isn’t likely to happen

By Jason Kephart

Mar 10, 2013 @ 12:01 am (Updated 4:57 pm) EST

rates rising sharply enough to cause the kind of big losses in bond funds that could send investors fleeing.

The bad news is, the scenario that he does see unfolding still is pretty bleak.

Mr. Gross expects the return on bonds to drop to the 2% to 3% range — sharply lower than their 8% historical average — meaning that with normal inflation, the return effectively would be zero.

He sat down recently to discuss his outlook on bonds, interest rates and why the so-called great rotation out of bonds isn’t likely to happen.

InvestmentNews: Over the past four years, assets in bond mutual funds have more than doubled to over $2 trillion. How should financial advisers be thinking about their bond portfolios?

Mr. Gross: The future for bonds is a lower-return future than in-vestors have come to assume. Bond investors should be expecting 2% to 3% returns over the future years. What we caution — and not just because we’re a bond shop — is that bond returns will be lower than expected, but the important thing is, they’re still better than cash and will provide positive returns.

InvestmentNews: It doesn’t sound as if you are very concerned about interest rates rising quickly and causing big losses in bond funds. How do you see interest rates moving?

Mr. Gross: I call it a smile. I’ve got a happy-face button on my desk. It’s got the two eyes and a gradual little smile for its mouth. The way we see it, interest rates are like the very gradual smile on the right side of the face, so to speak. Interest rates, on the 10-year [Treasury], for example, will rise 10 to 15 basis points a year.

A big spike in interest rates is certainly a worry for bonds, but it wouldn’t be friendly for stocks, either.

InvestmentNews: If interest rates aren’t a big concern, what is?

Mr. Gross: As a bond investor, I would be afraid of inflation. Inflation is the enemy of bonds. At the moment, it’s very controlled at less than 2% a year. You need to be able to discriminate which bonds will be affected by inflation. Eliminate your long-term bonds and start to look outside the U.S. for countries with a less bearish outlook.

InvestmentNews: The Federal Reserve’s quantitative-easing programs have played a big part in the pricing of bonds and interest rates. How long can they keep it up?

Mr. Gross: No one really knows, and perhaps even [Fed Chairman Ben S. Bernanke] doesn’t know when QE is going to end. We have a sense that the Fed will continue QE until real growth is stabilized in the 2% to 3% range for at least six to 12 months. The earliest that would be is January 2014.

InvestmentNews: What happens when the Fed stops buying assets?

Mr. Gross: There’s a chance interest rates will start to go up, or they lose control of asset prices, which they’ve delicately been trying to engineer. What we saw [Feb. 20] and a little bit [Feb. 21] is evidence that when the Fed stops writing checks, stocks, high-yield bonds and other risk assets are at risk. The risk is that they produce a 10% to 15% bear market in stocks by ending QE too soon — and therefore a potential new recession.

InvestmentNews: High-yield bonds have been popular for investors looking for yield. How should advisers be thinking about high yield?

Mr. Gross: Our research does suggest there’s a higher risk in buying high-yield bonds today than there was 12 or 24 months ago. If you’re buying a high-yield bond at 6% today, recognize that there isn’t much room for capital appreciation.

InvestmentNews: With the outlook for bonds dim, do you see investors moving more into stocks?

Mr. Gross: The great rotation from bonds to stocks doesn’t really have legs. The world is getting older by the day. That plays right up the bond market alley. The world is going to be dominated by bonds. A 68-year-old retiree in Des Moines, Iowa, can’t afford to buy Apple [Inc.] at $700 and watch it go to $450. They can’t have their 401(k) turn into a 201(k). Bonds are almost a necessary strategy in many cases.

InvestmentNews: If that is the case, what was the reason for ex-panding into active equities at Pimco?

Mr. Gross: It was just a matter of filling out the menu. We don’t want to be In-N-Out Burger and only have one or two things on the menu. We want to be the Cheesecake Factory. We call ourselves “your global investment authority,” and we already offered commodities and a few other things. It’s the right business strategy. It’s not something that said, “Hey, stocks are going to take over the world.”

InvestmentNews: So advisers are going to have to be happy with their 2% to 3% bond returns?

Mr. Gross: The media used to be optimistic and promote the expectations of sugar plums and tooth fairies. When you go on TV, it’s a better business strategy to say, “We can get you 5% or 10% returns.” [Pimco has] always thrived on straight talk.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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