Fear rising with rates

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.

MORE VOLATILITY

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.

TURNING POINT

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.

DEMOGRAPHICS

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.”