Bond investors get a glimpse of what's coming — and it ain't pretty

May served as a preview of where the bond market could well be headed

Jun 5, 2013 @ 4:19 pm

By Jason Kephart

If advisers weren't already spooked enough by the threat of rising interest rates, May served as a scary reminder of just how widespread the carnage could be. It's caused some to start looking for alternatives and others to prep their clients for the inevitable pains of staying with pure bonds.

Interest rates shot up a startling 50 basis points in May thanks to concerns over the Federal Reserve Bank tapering its quantitative-easing program sometime this year. The move left hardly any bonds undamaged in its wake. Every bond fund category at Morningstar Inc. posted a negative return for the month, save for bank loans, which ended the month virtually flat.

Even Bill Gross, manager of the world's largest bond fund, couldn't escape. His flagship $282 billion Pimco Total Return Fund (PTTAX) lost 1.9% in May, its worst showing since September 2008.

Interest rates have come down since the 10-year Treasury bond peaked at 2.23% on May 29, but things are likely to get worse before they get better.

WHAT TO READ Bill Gross' latest tweets on the bond market

“There's a lot more room for rates to go up than down,” Financial Industry Regulatory Authority chief executive Richard Ketchum told Reuters in a recent interview. “Losses of 5 to 10% are perfectly reasonable to expect. They may be safer than many investments, but they're not riskless.”

The dire outlook is causing advisers such as David Diesslin, CEO of Diesslin & Associates Inc., to rethink how to handle bonds.

“We can't eliminate bonds, but we want to minimize the negative implications of rising rates,” he said.

Mr. Diesslin has been placing more trust — and client assets — in bond funds that give managers flexibility to invest across multiple geographies and asset classes. He's also been adding conservative dividend-paying stocks and looking at alternatives such as direct real estate investment.

“It's challenging our concept of the 60/40 portfolio,” Mr. Diesslin said of the current state of bond investing. “It's a risk management situation.”

Bond fund managers have been relishing the freedom to get away from investing strictly in bonds, as well.

“Investors don't want to see negative returns coming from their fixed-income allocations, so having flexibility is an important tool for a rising-rate environment,” said Kathleen Gaffney, portfolio manager of the recently launched Eaton Vance Bond Fund (EVBAX).

Ms. Gaffney, who co-managed the $23 billion Loomis Sayles Bond Fund (LSBRX) with Dan Fuss for 15 years, has been flexing her go-anywhere muscles since the fund was launched in January. The Eaton Vance Bond Fund has a 15% allocation to dividend-paying equities and a 15% allocation to equity-sensitive convertible bonds.

The stock allocation helped buffer the fund from May's rising interest rates. It gained 0.17%, even as the benchmark Barclays U.S. Aggregate Bond Index fell 1.92%.

Bond funds that offer protection from rising interest rates generally were a disappointment in May, however.

Bank loans, which have soared in popularity thanks to their built-in buffer against rising interest rates, didn't get any extra oomph in May. Since the debt instruments are tied to short-term rates, not long-term rates, their interest payments weren't reset along with the soaring rate of the 10-year Treasury.

Nontraditional bond funds and global bond funds, which likewise have gained popularity thanks to their freedom, lost 0.15% and 2.64%, respectively.

Those three bond fund categories combined to take in $45 billion, 51% of all taxable-bond inflows, this year through the end of April, according to Morningstar.

Total mutual fund sales figures for May aren't available yet, but two of the four largest bond funds have reported flows so far and they paint a gloomy picture for the vanilla intermediate-term-bond funds.

Investors pulled $1.3 billion out of the Pimco Total Return Bond, its first net outflows since December 2011.

The $40 billion DoubleLine Total Return Fund (DBLTX) fared better, taking in a net $293 million, but it was still the lowest month of inflows since December 2010.

Both funds averaged about $1.5 billion in inflows a month in 2012, according to Morningstar.

Not everyone is ready to throw in the towel on the traditional way of investing in bonds, however.

Derek Tharp, a financial adviser at Mote Wealth Management LLC, has been spending his time preparing clients to see losses in bond funds in the hope that it will make them less likely to panic when they actually see red on their statement.

“We've talked to our clients about how losses on paper will be inevitable,” he said. “As long as we're holding on to them for the long term, it won't result in an actual loss.”

So far, Mr. Tharp hasn't heard any rumblings from clients about the last month's bond volatility.

“It's not as scary as the bottom falling out of the [stock] market,” he said.

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