Rising rates test resolve of investors who piled into bonds

© Reuters. Dawn Fitzpatrick, global head of equities, multi-asset and the O'Connor hedge fund businesses at UBS Asset Management, speaks during the Reuters Global Investment Outlook Summit in New York

By Trevor Hunnicutt and Sam Forgione

NEW YORK (Reuters) - Investors who piled into bond funds for safety will see red when they unfurl their current account statements this holiday season.

Retreating from stocks in 2016, fund investors plunged $194 billion in U.S.-based bond funds in the first three quarters this year, according to the Investment Company Institute, a trade group.

Yet interest rates have leapt in recent weeks, along with expectations of inflation under the new Donald Trump U.S. presidential administration, eating away at bond prices.

The benchmark 10-year Treasury bond's yield is 2.35 percent, up from 1.86 percent on Election Day.

"Core" bond funds, where a fifth of U.S. fixed-income fund assets are held, are off 2.3 percent so far this quarter, according to fund research service Thomson Reuters Lipper. If that result holds, this will be the largest decline since 2013.

Other bond funds have fared worse, especially those with exposure to longer-term bonds and emerging markets.

"Investors, both institutional as well as individual, will begin to receive statements which show losses rather than gains," said Steven Einhorn, vice-chairman of hedge fund Omega Advisors Inc.

Some investors see those results setting the stage for a rotation from bonds back to stocks.

And fixed-income fund managers are favoring bonds that act more like stocks. Those funds are revamping their portfolios, peeling away exposure to rate-sensitive government bonds and doubling down on higher-yielding corporate bonds, which are exposed to credit risks similar to stocks and typically move less in response to rate shocks.

"It's a very precarious state you're in: you're earning a really low return and you have really high risk," said Ellington Management Group LLC Chief Executive Michael Vranos at the Reuters Global Investment Outlook Summit in New York this week. "I don't know who has the stomach for that risk when it starts to move against you."

Investors are already starting to pull money out. U.S.-based taxable bond funds just posted their third straight week of withdrawals, with $5.9 billion pouring out during the seven days through Nov. 16. Municipal bond outflows of $3 billion during the week were the largest in more than three years, according to Lipper.

'LOYAL TO THEIR BONDS'

It is of course possible that demand will be strong for bonds even as investors start to see losses. Rising rates also mean bonds start offering more attractive yields to starving savers.

And portfolio managers, many of them hawking ostensibly safer alternative investments, have been predicting a great rotation out of bonds for years only to be humbled as rates tumbled lower.

"I've actually been blown away this year that you've had just this persistent demand in fixed income," said Rick Rieder, BlackRock Inc's chief investment officer of global fixed income.

"It's been pretty amazing to me that with rates moving as low as they did that you didn't see movement into the equity market, and it tells you that people are incredibly loyal to their bonds."

That has not always been the case. Bond markets panicked over the Federal Reserve's talk of removing life support from the economy in 2013, a "Taper Tantrum" that led to $59 billion in withdrawals from the funds that year, according to ICI.

EQUITY-LIKE CREDIT RISK

As the bond market throws its "Trump Tantrum," even more portfolio managers are rushing to credit to cushion the blow from rising rates.

Money managers said they remain bullish on U.S. high-yield corporate bonds, a riskier area of the bond market that tends to move in tandem with equities, even as the bonds have rallied more than 14 percent this year on a global reach for yield amid low-to-negative rates worldwide, according to Bloomberg Barclays (LON:BARC) index data.

Several investors said that the rate of defaults in the market was unlikely to accelerate next year, leading these investors to favor the riskier, lower-quality segment of the high-yield market.

"If a catalyst for the equity market is potentially corporate tax evolution (and) greater growth in the economy, the high-yield market should be in pretty good shape," Rieder said.

Much of the rally in high-yield so far this year has been disproportionately in the higher-quality end of the market such as BB-rated bonds, while lower-quality single B- and triple C-rated bonds have largely missed out, said Dawn Fitzpatrick, global head of equities, multi-asset and the O'Connor hedge fund businesses at UBS Asset Management.

Those lower-quality issuers remained attractive as a result, Fitzpatrick said. She said high-yield bond coupons were more attractive than those on their safer investment-grade and sovereign counterparts, while the likely absence of a pickup in defaults would also benefit the high-yield market.

Low rates globally would continue to spur inflows into high-yield bonds, said Gregory Peters, senior investment officer at Prudential (LON:PRU) Fixed Income.

"I think high-yield still represents the best 'carry' globally," Peters said in reference to the higher coupons an investor can collect in high-yield bonds.

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