Since Sept. 5 when the yield on the 10-year hit a 25-month high at 2.975%, it has made a sharp reversal lower aided by the Federal Reserve's non-taper announcement. The yield today is at 2.645%, down 12 of the last 14 days. This presents anyone who was caught off guard by the spike in May and June with a great opportunity to lighten up on duration and move to an underweight allocation.
The reason for the decline is not only the Fed taper, but also political risk emanating from Washington, D.C. Investors worried about a government shutdown are selling risk assets and buying safe haven securities like U.S. government bonds. But fixed-income investors will have significant headwinds going forward including the eventual end of QE, strong outflows, a near-record equity market, and faster economic growth possibly increasing inflation data.
While Bernanke surprised the world when he announced he would not end the bond-buying program last week, most believe that it will end within the next several months -- with some speculating it may be as early as October. The taper will happen and interest rates will likely rise when it occurs. Behind closed doors Bernanke likely wants to wait until the fiscal risks are behind us before he begins curtailing the bond-purchasing program.
The melodrama in Washington is also having the effect of pressing down yields as people seek safer assets. However, the chances of a government shutdown remain slim as both sides of the aisle realize that they will be hurt politically from it. The current scare tactics being played are just political games in order to extract as much from the other side as possible. Once the impasse is settled on or slightly before Oct. 1, look for rates to rise on the news as investors move back to a risk-on stance.
Money is pouring out of fixed income mutual funds with ICI reporting that $5.5 billion was withdrawn from bond funds in the week of Sept. 11. Over the last five weeks, more htan $36 billion has been pulled from bond funds. Since the spike in interest rates began in May, over $66 billion has been yanked out.
Bond fund buying has been prolific in recent years with retail investors buying $855 billion in 2012 and $1.2 trillion flowing in between 2009 and 2012. The swing to outflows has been rapid and severe and presents a massive impediment for investors in the space. As retail investors place redemption orders, portfolio managers must sell positions to meet the requests. They then go into the bond market and search for bids for these bonds. With nearly everyone else experiencing the same selling, bids can be both scarce and discounted. This will impact NAVs on their funds, which will compound the problem as other positions are marked-to-market.
Investors should be even more conscience of their municipal bond fund positions given the duration risk to those securities. As muni bond prices fall, they will go from being priced-to-call to being priced-to-maturity, which will further increase their durations and add interest rate risk.
For those who keep an allocation to fixed income, and this is something I recommend investors do, they should look to bank and senior loans that were hit by the recent FOMC decision. Closed-end funds like Western Asset Variable Rate Strategic Fund (NYSE:GFY) and BlackRock Floating Rate Income Strategies Fund (NYSE:FRA) that contain mostly floating-rate loans provide a decent hedge to rising rates over the long term while trading at generous discounts to their NAV. Other funds like PIMCO Dynamic Income Fund (NYSE:PDI) that contain a derivative overlay to their underlying fixed-income positions using pay-fixed swaps also provide a hedge against interest rate risk, while providing the investor with steady monthly income.
While the bond market saw a bit of a rally following the dovish FOMC decision and drama in Washington, flows out of the sector plus the eventuality of tapering will present a medium-term headwind to fixed-income investors. The rally saw no technical support crossed by the five-, 10- or 30-year maturities while equity markets soared. The stock market near all-time highs will impose a massive opportunity cost on bond investors in the near term. Bond investors should use the opportunity to lighten up on their allocations and duration, or seek income investments that provide a hedge to interest rate exposure.