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A Wakeup Call for Bonds

July 11th, 2013
in contributors, syndication

Investing Daily Article of the Week

by Philip Springer, Investing Daily

With bonds no longer the automatic risk-free safe haven they were long perceived to be, investors need to monitor both the bond market and their own holdings more closely than before.

Since early May, the yield on benchmark 10-year US Treasury securities has soared from 1.6 percent to 2.7 percent this morning. Rising yields mean lower prices.

Follow up:

The trouble with bonds started with some signs of economic improvement, followed by two pronouncements from Federal Reserve chairman Ben Bernanke on a possible timetable for easing up on the gas pedal (but not putting the brake on) the Fed’s extremely easy monetary policy.

Then the latest jobs report from the US Labor Department, released this morning, said that employers added 195,000 jobs in June. In addition, job gains for April and May were revised upward by a combined 70,000 jobs.

This is good news for the economy, but bad news for bonds.

Investors poured an estimated $1.2 trillion into bond mutual funds and exchange-traded funds (ETFs) from 2009 to 2012. The reversal of that long-term dynamic is now underway, as investors pulled $79.8 billion from those funds in June, the most ever in a single month, according to TrimTabs Investment Research.

Many central banks around the world have communicated clearly that they will keep monetary policy aggressively easy in an attempt to bolster struggling economies.

Yesterday, the European Central Bank (ECB) and the Bank of England were the two latest, both committing themselves to keeping interest rates low indefinitely.

ECB President Mario Draghi’s statement of a de factoas long as it takes” stance came almost a year after he issued a promise to do “whatever it takes” to preserve the European currency union. Over the last 12 months, however, the ECB actually has done little more than previously.

In contrast, the rhetoric from the two biggest central banks, in the US and China, has been more confusing, with mixed messages that have disrupted world markets.

In any event, it’s clear that the US economy is doing much better than Europe’s. Japan seems to be improving from a very low base of economic growth. China and many other emerging markets are slowing down from a relatively high growth base.

With that background, it’s increasingly evident that the 30-year-plus bull market in US fixed-income markets (the world’s biggest) is over. The key question now is how fast interest rates will rise (with declining prices) and how you can best protect yourself.

Almost every type of bond lost money in the second quarter, as the category numbers below from Morningstar show. The categories are ranked in order of the amount of assets held in each, first for taxables, then municipals.

The only winning category was bank loans, which also have the second-best one-year performance. These funds are less sensitive to rate rises because their payments are linked to external indexes that change frequently.

High-yield (“junk”) bonds held up relatively well and are the 12-month winner. Issuers of these bonds tend to do better as the economy does, making them less rate sensitive. In addition, their higher yields provide a positive offset to loss of principal from rising rates.

The two biggest losers among the more popular categories would surprise many people. Emerging markets declined 6.8 percent, for several reasons.

First, they’re more closely tied to the Treasury market than many realize. Second, they’re hurt by a strong dollar. Third, they also suffer from a general investor withdrawal from so-called risk assets. Fourth, many emerging-markets nations are significant exporters of commodities, which have had sharp price declines.

Another big loser was the inflation-protected category, which dropped 6.6 percent. Many investors don’t realize that this category’s prices are directly tied to Treasury securities, primarily long-term issues. So they suffer more than most when rates rise. In addition, inflation expectations have dropped sharply of late, putting further pressure on the value of inflation protection.

Fund Returns Have Varied

It’s interesting to see how five of the nation’s most popular bond funds have fared lately. All are in the same broad category of taxable bonds, primarily with intermediate maturities. Some of these funds actually invest in many areas of the bond market, aside from the Treasury and corporate issues that typically are their primary focus.

Here are the five funds, listed in order of assets under management, with results for the second quarter, year to date and 12 months:

PIMCO Total Return, the largest bond fund by far, was mistakenly bullish on Treasury securities and emerging-markets bonds. It did the worst in terms of risk control. The Vanguard fund’s large stake in good-quality corporate issues, which are relatively rate sensitive, were a strong negative.

The other three funds fared better, primarily because all were more cautious about bonds in general. So they (1) reduced duration (sensitivity to rate swings) and (2) exposure to the more aggressive bond market subsectors.

Stability and risk control with bonds are now the order of the day, as investors strive to stay properly diversified.

 









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