Investors scramble out of ETFs focused on U.S. Treasuries

Investors of exchange-traded funds that buy U.S. government debt are signaling their conviction the Federal Reserve is intent on raising interest rates sooner rather than later.

After pouring into the ETFs to start the year, investors pulled $10.3 billion in March, the biggest exodus since December 2010, data compiled by Bloomberg show. The $7.86 billion iShares 1-3 Year Treasury Bond ETF alone lost a third of its assets from withdrawals, the most of any fixed-income fund this month.

The retreat shows how quickly ETF investors recalibrated expectations as Fed Chair Janet Yellen said March 19 that a strengthening U.S. economy may prompt the central bank to lift its benchmark rate six months after it stops buying bonds. While Treasuries have confounded forecasters by outperforming this year, ETF investors are shifting money into riskier assets such as junk loans and small-cap stocks to capture greater returns.

“When the market thinks the Fed is going to raise rates, they don’t tend to stick around in short-dated bonds,” Thomas Higgins, global macro strategist at Standish Mellon Asset Management Co., which oversees $167 billion of fixed-income assets, said in a telephone interview from Boston. “With the Fed signaling rate hikes and the economy slowly but steadily humming along there is less and less value in Treasuries.”

Mr. Higgins said his firm favors speculative-grade corporate bonds and has been selling Treasuries.

The redemptions in March have all but erased the net inflows U.S. government bond ETFs garnered in the first two months of the year, when an economic slowdown in China, crises from Thailand to Ukraine and questions over the strength of the U.S. economy caused investors to seek out the safest assets.

BOND EXODUS

Treasuries posted their biggest returns since 2010 in January and February, with yields on the benchmark 10-year note falling almost a half-percentage point from a 29-month high at the start of the year to a low of 2.57 percent last month.

This month, U.S. government bonds have been the target of the most-acute selling among ETF investors, pushing up yields on 10-year Treasuries to 2.72 percent last week. That trimmed the return on the notes to 3.5 percent for the year, which would still be the first quarterly gain since 2012.

The three ETFs that suffered the biggest withdrawals in March were all U.S. government debt funds, with BlackRock Inc.’s iShares 1-3 Year Treasury Bond ETF losing $3.9 billion, data compiled by Bloomberg show. The outflows accelerated after Yellen’s comments this month, strengthening the view that policy makers sees enough signs of growth in the U.S. economy to end its bond purchases this year and raise rates soon after.

CRYSTAL BALL

After inundating the world’s largest economy with more than $3 trillion with three rounds of quantitative easing since 2008, economists predict the Fed will stop buying bonds by December.

The central bank has curtailed its monthly purchases by $10 billion at each of its three policy meetings this year.

Traders anticipate a 64 percent chance the Fed will start increasing its benchmark rate, which has been close to zero for six years, in June 2015, based on futures trading on the CME Group Inc.’s exchange. Prior to Ms. Yellen’s comments, the likelihood was 42 percent.

Recent reports on the U.S. economy have bolstered the central bank’s case. Confidence among consumers rose this month to the highest since 2008, exceeding all forecasts in a Bloomberg survey, as more Americans grew optimistic about the outlook for economy, according to a Conference Board index.

Household spending increased by the most in three months in February as employers added more workers than economists projected. Disposable income, or the money left over after taxes, rose by the most since September.

EMPLOYMENT PICTURE

Ms. Yellen meanwhile said in a news conference after the central bank’s March meeting that “virtually all” measures of unemployment she studies are showing improvement.

The Fed’s intent should tell investors to “get out of the way,” according to William Larkin, a money manager who helps oversees $520 million at Salem, Massachusetts-based Cabot Money Management. Mr. Larkin said his firm has been selling Treasuries.

Investors plowed money this month into ETFs that buy junk-rated loans, which have rates that rise with benchmarks. Their popularity has enabled the funds to boost their assets four times as fast as the rest of the $262 billion market for fixed-income ETFs, data compiled by Bloomberg show.

Inflation-linked debt ETFs also had their first monthly inflows in 19 months in March, the data show.

Exchange-traded funds that invest in U.S. stocks were even bigger beneficiaries, amassing $17.4 billion in the largest gain among all classes of ETFs, data compiled by Bloomberg show.

NO CUSHION

Funds that buy shares of the smallest American companies boosted assets by 5.4 percent, the biggest percentage gain.

“In this atmosphere, you need a cushion against higher rates and Treasuries don’t offer much of a cushion,” Andrew Milligan, the Edinburgh-based head of global strategy at Standard Life Investments Ltd., which oversees about $270 billion, said in an interview. “Equities and higher-yielding bonds look better than most lower-yielding fixed income as the U.S. recovery seems to be on its way.”

Mr. Milligan said Standard Life holds a smaller proportion of short-term Treasuries than their benchmark allocation.

The Fed is building up investor expectations for economic growth that may ultimately prove disappointing, according to Robert Tipp, the Newark, New Jersey-based chief investment strategist at Prudential Financial Inc.’s fixed-income division, which oversees $335 billion.

The Fed’s preferred gauge of inflation, used as an indicator of U.S. consumer demand, has now fallen short of its 2 percent target for 22 straight months.

GREAT EXPECTATIONS

At the same time, forecasters have pared back their estimates for economic growth this year to 2.7 percent from 2.9 percent, even as they stick to their 3 percent projection for 2015, which would be the fastest in a decade.

“The market has taken the Fed at its word,” Mr. Tipp said by telephone. “That has created a very high hurdle for growth, which we haven’t seen. The Fed’s time line may be pushed back out and we could see a relief rally come back into the market.”

The longest-dated Treasuries, which are the most sensitive to losses as inflation and growth expectations pick up, indicate that some investors share Mr. Tipp’s concern.

Treasuries due in 30 years have returned 8.4 percent this year, pushing down yields every month. That compares with a 1 percent advance including reinvested dividends for the Standard & Poor’s 500 Index, the benchmark gauge of American equity.

Dan Heckman, a senior fixed-income strategist at U.S. Bank Wealth Management, which handles $115 billion, is more sanguine.

‘POPPING CHAMPAGNE’

Steady long-term U.S. borrowing costs will foster a stronger recovery and advance the Fed’s twin goals of price stability and full employment as the central bank curtails its monetary support of the economy, he said.

The gap between yields of the five-year note and the 30-year bond has narrowed to 1.8 percentage points, the least since October 2009. Longer-term bonds tend to rise or fall based on the outlook for inflation, while shorter maturities are anchored by the Fed’s policy rate.

“The way the market has responded to tapering and the pushing up of a rate hike, the Fed has to be dancing a jig and popping champagne corks,” Mr. Heckman said.

(Bloomberg News)

Related Topics: Federal Reserve