Perhaps the biggest trade that has yet to happen in the financial markets is the hot-money’s exit from the U.S. Government Bond market. As the economy improves and as inflation begins to creep back into the mix (remember the Fed is trying to make both of these things happen) interest rates will rise. And as the textbooks tell us, rising rates means lower prices for bonds.
Now toss in the facts that (a) the Fed will eventually stop buying bonds, (b) hedge funds are likely to continue heading to the exits and (c) the government still needs to sell a boatload of debt this year and you are left with the question of why traders would want to continue to hold/buy this particular asset class.
As we have written in the past, we fear that the exodus of big money managers from the market will leave the average investor with big losses in an investment vehicle they bought in order to avoid just that. Unlike professional managers, who generally hold bonds to maturity and thus has very little risk unless the bond issuer defaults, the average investor owns bond funds, which fluctuate in value on a daily basis.
It is this misunderstanding that, in our humble opinion, leaves millions of investors at risk. Put simply, our bet is that the average investor doesn’t really understand how a bond fund works. The probably don’t really understand that when rates rise (and they will rise), they will lose money in their beloved government bond funds.
With the Fed still buying bonds via its QE2 program, rates have been fairly well behaved so far this year. However, let’s not forget that the yield on the 10-year did spike from 2.5% to 3.5% in a matter of two months as traders appeared to move out of bonds at the end of last year. And, again in our opinion, it is a safe bet that this type of pop in yields will likely take place again if the economy continues to improve.
Why worry about this now, you ask? In short, because the managers of the biggest bond fund in the world are. According to the company’s website, Pacific Investment Management Co. (aka PIMCO) was busy cutting back on its holdings of U.S. Government-related holdings in its flagship bond fund in December.
The holdings of Treasury’s, TIP’s, Agency bonds, and Treasury futures and options within the PIMCO’s Total Return Funds fell to just 22% in December, which is the lowest level in nearly two years.
Although Messer’s Gross and El-Erian continue to believe the world has entered a “new normal” period where emerging markets will rule and investors will be faced with lower returns, they also see things improving in the U.S. Apparently, the fund managers at PIMCO turned more upbeat on the U.S. economy after the President agreed to extend the Bush-era tax cuts. PIMCO says it now expect the U.S. economy to expand at a pace of 3% - 3.5% this year, which is up from its previous forecast of 2% - 2.5%.
So, if you happen to own government bonds, you may want to follow what the biggest of the big boys in the bond game are doing and cut back on those U.S. Government funds. After all, PIMCO has a pretty decent record of outperforming the bond market. Thus, if they are selling, maybe you should be too.
Disclosure: No position