How long will bond holders take disappointing returns?

MarketWatchJune 24, 2014 

There’s an old saying that the stock market can remain irrational longer than investors can remain solvent.

But when it comes to the bond market and dealing with interest rates, solvency isn’t the issue.

The bond market can remain irrational longer than investors can remain tolerant, and judging from the conversations at the recent Morningstar Investor Conference in Chicago, investors are running out of patience in this low-yield environment. That’s not entirely a new trend, but it is growing as the rate hikes that most investors expected to see in 2014 have been pushed back and now aren’t anticipated to arrive by most experts for 12 to 18 months.

Bond fund giant Bill Gross said in Chicago that he believes the bond market will be stuck in “the new neutral,” but that’s not a status that most investors will be willing to ride with for long.

Consider that at the conference, several conservative money managers — including some who run “unconstrained bond funds” that could seek out any type of fixed-income instruments anywhere — owned up to keeping large chunks of their portfolios in cash, guarding against what could happen when rates rise. The problem is that cash isn’t earning anything, and it’s got a negative real return — a loss — when you factor in the 0.75% or more those money managers are charging in expenses; thus, an unconstrained bond fund with 40 percent or more of its holdings in cash is going to have a hard time looking good in the performance column.

And when that happens long enough, investors will not be sympathetic. They are already starting to beat a path out the door to funds they think they can goose returns, and for most of those people those changes are occurring without even knowing what any lagging bond fund is doing to dampen its performance, and whether the manager is sacrificing short-term numbers for longer-term positioning.

“If the bond market and bond funds were a dam trying to hold back the assets in traditional conservative holdings, there are a lot of cracks in that dam and it’s leaking into more credit-sensitive strategies,” said Eric Jacobson, co-head of active fixed-income strategies at Morningstar. “My fear is that people have no idea how much more risk they’re taking now than they were before.”

The issue is central to the asset allocation of individual investors, many of who are still fearful of a market downturn, feeling burned by the financial crisis of 2008 despite a five-year-plus bull-market rebound since.

Having sought safe havens — and having been rewarded for those choices — investors are overweight bonds, and have been happy to get annualized average returns north of 6 percent from intermediate-term bond funds over the last five years.

The problem is that those average returns have been decreasing — the average intermediate bond fund is up about 3.5 percent over the last 12 months, according to Morningstar — and with that, investor patience has been decreasing.

It’s no secret that whenever the Federal Reserve raises interest rates, bond funds will suffer. When yields rise, bond prices fall, and mutual fund prices are set by determining what the fund would be worth if every holding was liquidated at the end of the trading day. When rates rise, the underlying paper would bring a less-attractive return, cutting into the fund’s share price.

The further out the duration of the bond, the greater this short-term pricing impact.

Thus, if investors lose their patience and tolerance of low-rates now and start to stretch for yield by riding up the risk curve — taking a chance on longer maturities or riskier credit instruments — they will be setting themselves up for trouble.

For every investor who thinks they can put that trouble off, they need to look at just how badly they called the market for 2014. The vast majority of money managers and economists surveyed in a number of polls late last year said they would have expected a rate hike by now. Had they acted on that — and many did — their call wasn’t necessarily wrong; it may have just been early.

But for investors who act now thinking that a rate hike is still a ways off, they might be early (again) or they might be wrong.

What they should be, for now, is tolerant, accepting that their strategy may be in stasis for the foreseeable future, because the price for getting jumpy right now could be steep when rates move later.

Chuck Jaffe is senior columnist for MarketWatch.

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