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The fear mongering surrounding a supposed imminent destruction of your U.S. bond portfolio is reaching fever pitch. Part of that fear mongering is the rampant talk surrounding a forthcoming "Great Rotation" out of bonds and into stocks. Cries from the world of equity investors about much higher bond yields have been heard for nearly four years now. Perhaps if the pundits keep saying it over and over, they will eventually be right. But for now, very normal seasonal moves in bond yields continue to be misinterpreted as something much more. For the purposes of this article, rather than enter into the debate about when yields might go higher, I'd like to address what might happen if they do go higher.

A "Great Rotation," whereby investors sell their bonds as yields rise and move that money into stocks, is something that I doubt is on the horizon any time soon, if ever. As we have seen from fund flows in recent weeks, it is possible for equities and bonds to simultaneously have inflows. And a simultaneous inflow scenario is one I find more likely to be the case than an equity inflow/bond outflow scenario, should positive equity flows continue for some time. Beyond the fact that it is a bit hypocritical of the same investors who preach not fighting the Fed in the world of stocks to advocate fighting the Fed in the world of bonds, there are other reasons a huge rotation out of bonds and into stocks is unlikely at any point in the foreseeable future, even if Treasury rates rise.

One such reason is the change in the psychology of investing resulting from two brutal equity bear markets in less than 10 years. Other reasons include demographic forces. And by demographic forces, I am not just referring to the typical higher fixed income weighting that often accompanies getting older. Instead, I am also referring to the effect that millions of retirees receiving pensions and investing in annuities will have on the investment decisions of those who manage pension funds and annuities. Those forces are unlikely to be supportive of a "Great Rotation." Additionally, higher capital requirements in the banking sector and an intense focus among regulators toward making sure that banks can handle periods of funding stresses in the future will be supportive of fixed income markets.

I am not saying it is impossible to get investors to sell their bonds every once in a while. But to get a longer-term "Great Rotation" seems highly unlikely to me. It seems to me more likely that inflows into stocks come from money markets and/or new cash being earned by individuals. What would it take for me to exit my bond investments in a massive way? One of two things: I would have to be convinced that hyperinflation was imminent. Or equities would have to crater from today's levels. If instead stocks keep rising, then my flows into equities are most likely going to come from future savings. But if bond yields concurrently rise with equities, as many investors seem to be expecting, then the bond market will be providing greater competition for my future savings. Therefore, it is no guarantee that my "cash on the sidelines" would head into stocks at higher prices. After all, just as equity investors like to buy dips, so do bond investors. Rising yields and declining prices would present many wonderful opportunities for bond investors to average into positions that mature at par.

Besides what I think is the nonsensical talk surrounding a forthcoming "Great Rotation," I would also like to address another piece of nonsense I constantly read and hear in the financial press: If Treasury yields go higher, your bonds will lose money, especially your longer-duration bonds. First, I would like to point out that, in general, fixed income investors purchase bonds for income, and not for capital gains. Bond prices may go up, and they may go down. From my perspective, that is largely irrelevant. To me, cash flows and credit risk are the most important factors of bond investing. Liquidity is a concern from a total portfolio perspective. And as long as I have planned my liquidity needs well, then selling bonds that will mature at par at prices below my cost basis becomes unnecessary. As such, the movement of bond prices is largely irrelevant, and would never cause me to jump ship from bonds and move the money into stocks.

Second, keep in mind that if you purchase a 10-year Treasury and hold it for three years, the movement of the 10-year Treasury will no longer be relevant to you. Instead, you will then own a seven-year note, and the price and yield of a seven-year Treasury is what you should concern yourself with. In the steep yield curve environment in which we live, riding the yield curve can help protect you from rising yields.

Moreover, while it is true that if Treasury yields head higher, your Treasury bonds will drop in price (how many people do you know who actually own a lot of Treasuries?), it is not necessarily true that if Treasury yields head higher, your corporate bonds (LQD) will decline in price. In the world of corporate bonds, spreads matter. If you purchase a corporate bond when spreads have widened, then rising benchmark Treasuries might not end up being a huge concern of yours. Also, remember that just because the broader corporate bond market might not be trading at enticing spreads does not mean that certain individual bonds aren't either. To illustrate just how much spreads can matter when purchasing corporate bonds, let me use some examples of longer duration bonds I own in my portfolio.

On August 28, 2012, the 30-year Treasury traded at 2.75%. On that date, I purchased CUSIP 24668PAE7, a 10/1/2040 maturing bond of Delhaize Group (DEG). After commissions, I paid 82.405 cents on the dollar. Since that time, the 30-year Treasury has risen roughly 40 basis points. Using the far-too-simplistic logic I so often read in the press, the price of the Delhaize bond should be much lower than that at which I purchased it. Instead, if you want to purchase this bond today, you will pay 99.25 cents on the dollar (before commissions), for a yield-to-maturity of roughly 141 basis points less than the 7.1637% I received. Why did the price of that bond rise (and yield drop) by so much despite a rise in long-term Treasury yields? Spread contraction.

Second, the last corporate bond I purchased in 2012 was that of AngloGold Ashanti Holdings Finance (AU). It matures on 4/15/2040 and has a coupon of 6.50% (CUSIP 03512TAB7). I paid 98.225 cents on the dollar for a yield-to-maturity of 6.641%. Since October 19, 2012, the date of my purchase, the 30-year Treasury has risen in yield by about 21 basis points. The AngloGold Ashanti bond, however, rather than dropping in price, has done the opposite. If you want to purchase it today, you can do so for 101.931 (before commissions), a yield-to-maturity of 6.349%. Despite benchmark yields rising by more than 20 basis points, that particular bond's yield dropped by roughly 30 basis points.

Third, on January 3, 2012, I purchased Bank of America's (BAC) 1/5/2021 maturing senior unsecured corporate bond with a 5.875% coupon (CUSIP 06051GEE5) for 96.317 cents on the dollar. The yield-to-maturity was 6.42%. Today, you will pay 118.491 cents on the dollar to purchase that same bond. The current yield-to-maturity is 3.206%. The yield has dropped more than 300 basis points in just over one year. During the same time, a nine-year Treasury is effectively unchanged in yield (although the benchmark to the BAC bond would have benefited in price from moving down the yield curve a bit).

I am not implying that the experience I've had with corporate bonds will happen to everyone. But I am stating that you should not believe the blanket generalities you will often come across regarding bond yields and bond prices. Besides the Delhaize, AngloGold Ashanti, and Bank of America bonds mentioned in this article, I have other examples in my portfolio that illustrate the importance of spreads in the world of corporate bonds. The examples also illustrate how much of what you read about the imminent implosion of your bond portfolio need not necessarily be true, even if you own longer duration bonds and yields head higher. Of course, if you are like me and care first and foremost about credit risk and cash flows, then, as I mentioned earlier, you will largely ignore the mark-to-market changes in the portfolio.

Furthermore, even if you are a bond fund investor, depending on the type of bond fund you own, you can experience rising bond prices in a rising stock market and rising Treasury yield environment. On June 1, 2012, I purchased the iShares High Yield Corporate Bond ETF, (HYG), at $86.50. Since that time, stocks have rallied, Treasuries with similar durations to HYG's have risen in yield, and the price of HYG has also risen, by a little more than 7.50%. The reason for HYG's advance in the face of rising benchmark yields was, once again, spread contraction.

The next time you come across an article that discusses the "Great Rotation" or the idea that rising Treasury yields will absolutely cause your bond portfolio to suffer tremendously, think about some of the things mentioned in this article. I recognize that each of us has our own investment strategy. But when crafting those strategies, it is important to search for all relevant information and not just those opinions and facts that dominate the mainstream media. With that in mind, I hope you find this article useful as you think about and craft the fixed income portion of your portfolio.

Source: The 'Great Rotation' And Other Nonsense