Bond rout: Just a blip or sign of bleak future?

Jun 9, 2013 @ 12:01 am

By Andrew Osterland

Investors are getting a taste of what rising interest rates can do to their fixed-income portfolios, but bond experts don't think that the sharp rise in rates last month signals a coming rout in the market.

The yield on the 10-year Treasury bond was up 46 basis points in May, resulting in a loss of 3.7% for the month.

The benchmark Barclays U.S. Aggregate Bond Index, which tracks the broader bond market, was down 1.92%, and every bond fund category except for bank loans had a negative return, according to Morningstar Inc.

“May was one of the worst 20 months for the 10-year bond since 1950,” said Chris Orndorff, senior portfolio manager at Western Asset Management Co. “When market rates are 7% or 8%, a 50-basis-point move isn't a big deal, but when rates are this low, it is.”

The burning question for financial advisers and their clients is whether the rate spike last month was merely a reaction to the rally in March and April or the beginning of a sustained rise from historically low interest rate levels that could wreak havoc on investment portfolios for years to come.

“This last run was pretty abrupt, and we may see some bounce-back, but interest rates were going to go up, and it's as good a time as any for that,” said Jim Heitman, an adviser with Compass Financial Planning.

He admittedly has been wrong about rates for the past two years but still thinks the only direction they can go from here is up.

“I've been wrong for a while, but I may be right this time. This could be the beginning of the process,” Mr. Heitman said.

Most fixed-income analysts don't see much risk of a rapid rise in rates from current levels.

“In the absence of the Fed, the outlook for rates would be about the economy and inflation,” Mr. Orndorff said. “That story would be conducive to a bond rally even from these low yield levels.”

With the still-weak U.S. economy and no indication of rising inflation despite the loose monetary policies being pursued by most of the world's central bankers, the environment would seem to argue for continued low interest rates. The wild card, however, is how Federal Reserve policymakers view the landscape.

In a market climate where monetary policy has become the most important factor for investors, Fed watching has become a national pastime. For analysts, it isn't just about determining how the market will react to economic data but how the Fed will, and — perhaps more importantly — how the market thinks that the Fed will.

“Monetary policy is now the most important thing for investors across global markets,” said Rick Rieder, chief investment officer of fixed income at BlackRock Inc. “It dwarfs the importance of the economic data.”

FED SPARKED SELL-OFF

Indeed, it was comments from Federal Open Market Committee members such as Philadelphia Fed President Charles Plosser about reducing the Fed's purchases of long-term Treasuries and mortgage-backed securities that sparked the sell-off in bonds last month. And while the still-anemic growth in payrolls reported last Friday normally might have spooked stock investors, the market rallied because the weak numbers likely mean no tapering-off of the Fed's quantitative-easing program.

The sensitivity to ambiguous signals from policymakers is making the bond market a far more volatile place and contributing to some wild price swings based on flimsy reasoning.

Brian Rehling, chief fixed-income strategist for Wells Fargo Advisors, thinks that fears of a shift in monetary policy are over-blown.

“It's the more hawkish nonvoting members of the [Federal Open Market Committee] that have been talking about tapering the asset purchases,” he said. “The more important members are Ben Bernanke, Janet Yellen and William Dudley, and they're still in the dovish camp.”

Mr. Rehling expects a gradual trend upward in rates, and he has a year-end target on the 10-year bond of 2.25%.

He favors corporate bonds over Treasuries and said that recent sell-offs in the high-yield, bank loan and preferred-securities markets soon may present some buying opportunities in those sectors.

“I don't see a rotation out of fixed income. In fact, I see people continuing to buy,” Mr. Rehling said.

“That attitude could change, but I don't think it's likely in the next six to 12 months,” he said.

Mr. Orndorff has a slightly higher year-end estimate of 2.5% on the 10-year Treasury, but he, too, doubts that the spike last month portends a rout in the bond market. With the U.S. economy chugging along at a modest growth rate of about 2% and inflation still in check, the conditions for a rapid rise in rates just aren't there.

“It's going to take more than May to cause investors to panic,” Mr. Orndorff said. “The presence of the Fed as a price-insensitive buyer puts a cap on where rates can go.”

Mr. Orndorff also thinks that there are enough uncertainties on the horizon, such as the debt ceiling debate, Europe's continuing problems and Mr. Bernanke's possible exit as Fed chairman at the end of the year, to keep the economy subdued and the Fed priming the pump.

Nevertheless, Grant Moore, an adviser with Savant Capital Management, thinks that the recent spike in rates could be the beginning of an extended rise.

“Once we start seeing the economy turn around, the only option is for rates to rise. We're starting to see that now,” Mr. Moore said.

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