Taking stock of a big bond rally

MIXED SIGNALS MAKE FOR CONFUSING LANDSCAPE

Bonds have been on a hot rally lately. Everything f r om high- yield corporates to U. S. Treasuries have seen their prices soar, and fund managers who went underweight this year have been left scrambling in an effort to chase returns.

Coming off an incredible March and April performance, bond investors are wondering where the rally goes from here. Is it time to take your profits and run? Or can bonds put on even more gains before 2016 closes out?

The investment landscape at the moment is certainly a confusing one. In December, following the U. S. Federal Reserve’s interest rate hike, it appeared that as many as four additional hikes this year would drive up yields. But t he recently dovish comments from Fed chairwoman Janet Yellen throw that scenario into doubt.

At the same time, bond markets are coming off a major rout in the first two months of the year that saw credit spreads among corporates widen the most since 2011. Analysts noted the widening suggested investors were bracing for a U. S. recession.

But the volatility is no reason to pile out of bonds, say fund managers. In fact, the volatility means that bonds play an even more important part in asset allocation this year, because even if the Fed hikes, a well diversified bond portfolio still has room to make money.

“Today yields are low but spreads are really wide. If good things can happen in the world and the economy, then treasury yields might rise, but spreads will narrow,” said Jim Caron, head of global fixed income at Morgan Stanley Investment Management.

Investors, however, would be justified in being hesitant about increasing their bond exposure. Data from ETF. com shows that six of the 10 funds with the biggest inflows this year are bond funds, while all 10 of the biggest losers are equity funds.

The trend has been clear: investors have been piling into bonds at a massive pace while ditching stocks. That risks creating a pullback as investors take profits off the table.

“From a historical perspective, returns have been about as good as it gets,” said Steven Major, managing dir- ector of global fixed income research at HSBC.

There are other reasons to be cautious — including the sharp uptick in defaults among high- yield corporate paper.

Ratings agency Standard & Poor’s noted this week that defaults for high- yield corporate bonds, or junk bonds, are at their highest level in six years. Roughly 3.8 per cent of companies covered by S& P that have the speculative-grade debt rating have defaulted, the highest level since 2010. Twelve companies defaulted in March alone.

Betting against bonds, however, has not been a very profitable play. Caron of Morgan Stanley notes that since 1978, U. S. Treasuries have only seen three years with an annual negative return, including 1994, 1999 and 2013 — the year that concerns about the end of quantitative easing caused short- term angst among investors.

At the same time, the recent trend of negative bond yields in Europe and Japan show that zero is no longer the floor. While the discussion in recent years was how low could bond yields go before investors abandoned the asset, negative interest rates show that bond prices still have plenty of room to run as long as investors are willing to pay for safety.

Even better-than-expected economic growth appears less of a risk to bonds in 2016 than it has in previous years. Caron notes that while it would only take a 50 basis point rise in Treasury yields to wipe out this year’s gains, the corresponding rally in corporate bonds that would follow rosier economic data would help offset that.

So investors who diversify in both government bonds and corporates could win no matter how the rest of 2016 plays out.

Still there are those who warn that the sell- off of January and February could repeat itself following the recent rally. Larry Dyer, managing director at HSBC, said in a note that investors should think about limiting further bond exposure after the blistering March performance.

“I think markets are too close to our targets for comfort,” he said. “I have been focusing on the typical trading ranges for U. S. rates to try to increase returns and manage risks with the market near our target. This approach argues for taking risk off the table after a significant rally.”

TODAY YIELDS ARE LOW BUT SPREADS ARE REALLY WIDE.