Ever since the Federal Reserve launched its record-level quantitative-easing program more than five years ago, the financial markets have been fixated, and rightly so, on the eventual exit strategy.
Although the Fed's purchase of more than $4 trillion in U.S. debt as a means of managing interest rates is uncharted, an ultimate wind-down has always been expected. And even though the wind-down begins this month with a $10 billion reduction in the $85 billion pace of monthly bond buying, the ultimate impact on the financial markets remains uncertain and dynamic with so many variables still in play. The Fed did remove one major factor in its December comments by reminding the market that its near-zero rate policy hadn't changed.
Most market analysts now see the Fed's short-term rate staying put until at least 2015, and that has been embraced as good news for most financial markets. But what was left unsaid is how the tapering process will unfold from here, which is where financial advisers and their clients will need to pay careful attention in the months ahead.
As if on cue, the yield on the 10-year Treasury jumped to a three-month high the day after the Fed's Dec. 18 tapering announcement. But anyone paying attention in May, when Fed Chairman Ben S. Bernanke first hinted that tapering could begin in September, shouldn't have been surprised by the yield spike.
“The May-June time period was a big shot across the bow when we saw the 10-year Treasury yield jump 65 basis points, and most major bond funds were down about 5%,” said J. Brent Burns, president of Asset Dedication, which builds fixed-income separate-account portfolios.
As he sees it, an already challenging time for fixed-income investors could become even more so now that tapering has begun.
“If you already own individual bonds, all you can do is hold them to maturity, because they will lose value as rates rise. If you're a bond fund investor, you should get out,” Mr. Burns said.
“Unlike the stock market, which is a random walk, in the bond market, yields are connected to interest rates, and that means portfolio managers will be selling at a loss because any bond fund that has a total-return approach has a baked-in structural component that will not do well in rising rates,” he said.
In essence, the bond market right now is “like a freight train that you can see coming a long way off, and all you need to do is get off the tracks,” Mr. Burns said.
The theory holds that as tapering kicks in and likely increases over the next year to 18 months, yields will rise on most bonds because such a major buyer of debt as the federal government is starting to push away from the table. But as seen with last month's announcement, the Fed plans to keep reminding the markets that it has no immediate plans to raise the short-term rate that was set at near zero even before the first round of quantitative easing began.
“In the short run, with the start of tapering, we could see some increased market volatility,” said Greg Davis, incoming head of the fixed-income group at The Vanguard Group Inc. “But people need to keep in mind that any case for tapering means we have an improved economic situation.”
Such statements are standard fare among those in the fixed-income ranks these days. It is obviously in the best interests of a lot of asset management companies that fixed-income investors don't go running for cover at the first sign of tapering.
But it also is probably in the best interests of most advisers and investors to approach tapering with a plan already in place.
“It is likely that initially, rates will go higher [once the tapering actually begins],” said Vitaliy Liberman, a portfolio manager at DoubleLine Funds. “But as people start to settle in and realize what tapering really means, they will realize that if rates do go higher, it will be a tremendous buying opportunity.”
To help put the fear of rising rates into perspective, Mr. Liberman pointed out that over the first 11 months of last year, the yield on the 10-year Treasury bond increased by 130 basis points, while the average intermediate-term-bond fund remained essentially flat.
“People tend to react to headlines and generally don't understand that there are many provisions that allow bonds to perform relatively well even during bad times,” he said. “If [last] year is an example of a bad scenario, with bond funds flat, then let's look at a good scenario.”
For most of last year, the Fed did just about everything in its power to warn the financial markets that tapering eventually would happen, which might help explain why the bond market didn't appear to overreact to the official tapering announcement in December.
It probably helped that the market essentially had been there before, thanks to the Fed's May comments that were widely interpreted as an actual September trigger date to begin reducing the bond-buying program.
But when tapering didn't start in September, some investors and market analysts felt slighted or even faked out by Mr. Bernanke.
Others used the market's reaction between the May suggestion and the lack of tapering in September as a kind of roadmap to what would likely happen next time around.
“Unfortunately, the Fed didn't start tapering in September as everyone expected, but now we can just recalibrate because we know we're going to go through the same thing we went through since May,” said Thomas Meyer, chief executive of Meyer Capital Group.
As he sees it, now that a tapering announcement has been made, investors can expect a certain pattern to unfold, including a bump in the yield of the closely watched 10-year Treasury.
“I'm clairvoyant. I can suddenly see the future,” Mr. Meyer said.
“It will be the same scenario, except the market this time is at slightly higher levels,” he said.
Wilmer Stith, co-manager of the Wilmington Broad Market Bond Fund, also thinks that the Fed did the market a favor with its September head fake.
“That playbook is something investors can use,” he said. “It may not look as violent as it did the first time around, but certainly, we should expect higher rates — and those areas that benefited from quantitative easing may take a pause.”
When it comes to vulnerability, government securities and mortgages “will not be a great place to be” once tapering is fully engaged, said Jim Sarni, managing principal at Payden & Rygel.
“There will have to be other buyers to take up the slack for the lack of buying and lack of demand for those securities once the government starts reducing its purchases,” he said.
The least vulnerable fixed-income categories, according to Mr. Sarni, will likely be bonds with the lowest credit quality.
“Some junk bond prices might suffer a bit in sympathy with a broader sell-off in the bond market, but they have a lower correlation to the rest of the bond market anyway,” he said.
“And municipal bonds have the potential to hold up even better than corporate high yield, because we're already seeing people throwing the baby out with the bath water in the muni space,” Mr. Sarni said.
One thing to keep in mind is how much of the taper threat was already priced into the market leading up to the December announcement.
“As soon as the tapering begins, it will be priced in, and people will then start focusing on rising rates,” said Michael Collins, senior investment officer at Prudential Financial Inc.
“You might even be able to make some money by buying the back end of the yield curve, where they are pricing in a lot of rate hikes,” he said. “The curve is so steep now [representing the yield differential between shorter- and longer-term bonds], there's actually an opportunity to make some money on the longer end of the curve.”