Why you might want to bail out of your bond fund investments now

With the Federal Reserve making official its plan to start dialing back the five-year-long quantitative easing program starting next month, J. Brent Burns, president of Asset Dedication, explains how the risk dynamics are likely to start shifting.
“Just because the economic factors say interest rates will go up, doesn’t mean they will,” he said. “But if you’re a bond fund investor you should probably get out.”
Here are five big questions the money manager tackles, as told to sister publication InvestmentNews.

InvestmentNews: How do you think the bond market, in general, will react to tapering over the next several months?
Brent Burns: I don’t’ know if I know how it will react, but I know how it ought to react. Lower demand means prices have to come down and yields go up. But that doesn’t mean that’s how it will play out.
Look back at S&P downgrading Treasuries in 2011 and how the yields on Treasuries actually went down. A lot of managers got stung by betting on the strategy that yields would rise after the downgrade.

IN: Does tapering create any new opportunities for bond investors?
Mr. Burns: The opportunity is really for bond fund investors. It’s been a lovely 32-year trend of rates falling. But there isn’t a whole lot further down we can go. But there’s plenty of room to go back up.
If you’re a bond fund investor, rising rates are just not fundamentally good. But if you hold an individual bond to maturity you’re okay. Your returns might be low but they won’t go negative.
For bond fund investors, I think it’s their opportunity to get out while the getting is still good.

IN: What kinds of new risks are you seeing in fixed income?
Mr. Burns: A lot of times investors get lulled into complacency when we haven’t had any major meltdowns in a while, and they start to drop their guard with regard to risk. I’m seeing more investors looking for alternatives and going to high-yield.
You want high-quality bonds that will hold up when everything else is falling apart. Nothing is falling apart right now, but at some point, something will.
The real risk might be where people have taken on more risk than they really want. A low-rate environment puts a lot of pressure on the portfolio and to try and squeeze more out of the bond portion adds risk that you might not ever get compensated for.

IN: Do bond investors have a lot of alternatives at this point in the market cycle?
Mr. Burns: I don’t see a whole lot of alternative to bonds, but I hear a lot about firms selling what appear to be alternatives to bonds. There are people pushing [real estate investment trusts] and various types of hard-assets and lease structures. They work kind of like bonds because they’re designed around cash flow.
They may be perfectly fine in a portfolio, but I don’t think they are really alternatives to bonds. Bonds are a unique asset class that have the ability to protect principal. When things go bad, most of the bond alternatives start to look like stocks

IN: What’s your perspective on what the Fed’s fiscal policy, including tapering, ultimately means for investors?
Mr. Burns: It has been a real challenge and will continue to be a real problem.
Rates are at more or less at all-time lows. About the best you can expect for at least the next several years is to collect the coupon. If that’s the case and there really is no total return juice, then most of the portfolio assumptions are all off.
If you have a bond portfolio that is going to do 2.5% and the assumptions are 7%, that means the rest of the portfolio will have to work harder. I’m worried that people might be overestimating what they can spend out of their portfolios. If rates are low or rising, you have to take the performance at face value and you have to be more conservative with your planning.
For an individual-bond investor, rising rates can be a good thing, but most people are in bond funds and they don’t get the benefit of that because the turnover in the portfolio prevents the manager from being able to protect the principal. Some of that portfolio turnover is forced by investors bailing out of the fund. And we don’t even really know what it ultimately would look like, because bond funds didn’t really exist in 1950s at the start of the last rising-rate cycle for bonds.
I don’t know if we would see that same kind of long sustained rising-rate environment. But it certainly makes sense that we will get back to sustained range of 5% or 6% on the 10-year Treasury.