7/3/2013 5:15 PM ET|
Dumping bond funds? Read this first
Experts have been warning of a building bond bubble for years; even if the market can avoid a catastrophic event, investors clearly expect a lot of pain when rates move up.
Wake up and get busy, or hit the snooze button?
That's not just the choice that most investors face every morning, it's what they had to decide recently after Federal Reserve Chairman Ben Bernanke hinted that the central bank will soon end its program of buying bonds to support the market and keep interest rates low.
While many observers felt that Bernanke was simply floating a trial balloon -- trying to gauge the market sentiment while also sparking some movement in a bond market that had grown increasingly complacent -- others took his words as a call to action, jumping out of their long slumber in bonds to move their money elsewhere.
As a result, through Monday, June 24, more than $61.7 billion had flowed out of bond funds and exchange-traded funds, according to TrimTabs Investment Research, a record rush for the exits that is nearly 50% larger than the prior record, set in October of 2008 as the market was reaching the peak of the financial crisis.
The move bucks a long and determined trend. Until June and Bernanke's statements, investors had been plowing money into bonds consistently, despite paltry yields, because they believed that the Fed would provide sufficient liquidity to prop up the market forever.
A month ago, junk bond yields were falling below 5% for the first time, a sign that investors who were still skittish about stocks (despite an equity run to record-high levels) were feeling that there wasn't much danger in bonds, even in paper that was classified as risky.
That changed with a few statements from Bernanke.
It's no secret how bond funds and the bond market works. When rates rise, bond prices go down; a bond fund's share value is determined by what it could sell those bonds for if it needed to liquidate, so if rates go up and prices go down, bond funds suffer.
Experts have been warning of a building bond bubble for years; even if the market can avoid a catastrophic event, investors clearly expect a lot of pain when rates move up, despite the relative safety of the asset class. Even if that pain is temporary -- and bond funds typically recover from the declines suffered during a rate hike by bringing in more yield as they buy new paper at the better rates -- investors don't want to feel it.
Thus, Bernanke's talk created a rush for the exits; June's record exodus marked the first month in nearly two years where bond funds saw net outflows.
The question, of course, is "What did investors do with that money?"
The answer, from TrimTabs' research and numbers released by the Investment Company Institute, is clear; it did not go into stocks. Through June 24, according to TrimTabs, only $400 million -- less than 1% of the bond outflow -- had been shoved into equity funds in June.
"That money is not going to stocks, it's going into bank products and money-market funds, even if investors don't think they will get any real return there," said David Santschi, chief executive officer at Trim Tabs Investment Research. "Bond money for most investors is considered their safe money; even if they don't understand the risks they believe that what they can't afford to lose they put into bonds, and while they might not be happy with a loss in a stock fund, they won't even tolerate the thought of a loss in their bond funds."
The question is whether such a loss in bond funds is imminent, and whether investors can afford to snooze right now and wake up later.
Michael Gayed, chief investment strategist at Pension Partners, said the current market movement has been an over-reaction, noting that "While there is a concern that bonds are over-valued -- that there is a bond bubble -- it's not really a bond bubble unless you have an end to deflationary forces."
With no such end in sight, at least for the rest of 2013 if not much longer, there is nothing to justify an immediate change to Fed policy or the higher yields that would drop bond prices and hurt bond funds.
Despite Bernanke's words and warnings, nothing seems to have changed; the market simply had a tantrum over his words.
For investors who are between snoozing and jumping out of bed, what's needed is a quick evaluation.
With Bernanke hinting at an inflection point where policy changes, investors should look at all of their income-oriented investments -- including dividend-producing stocks -- and consider rebalancing back to their planned allocations, rather than allowing market forces to push them forward, particularly in bond funds with longer maturities.
Said Santschi: "Is it scary how much the Fed is driving this market? Absolutely. But does that mean the average investor should be rushing to sell all of their bond funds? I don't think so. If you're careful, there is never a reason to panic, but there is really no reason to panic right now, and you're not going to help yourself if you see all this money leaving bond funds and you just think 'They're all going so I have to get out too.'"
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As a bond investor for the long haul I’m glad to see my bond prices falling and interest rates rising. This leaves me better off in the long run, thanks to the magic of compound growth math. For example: If I start by investing $10,000 in a bond fund with a 20 year average duration and a 3% reinvested coupon, it will be worth $18,060 and generate $540 in annual income after 20 years. If rates suddenly rise to 4% the next day, the market value of my $10,000 investment drops to about $8,650. That seems like a bummer. However, the future coupon income reinvested at a 4% yield (instead of only 3%) results in my investment having a higher end value of $18,930 and higher annual income of $660 after 20 years. If rates rise even higher to 5%, the annual income of my investment rises to $800 instead of $540 after 20 years. Furthermore, I can then withdraw about 26% more money for living expenses each year during the subsequent 15 years before my fund is exhausted.
I don’t know about you, but, I’ll take what’s behind door number two. Even though a rise in rates means I take a hit in the beginning from falling bond prices, I’m better off with more value and more income in the long run. Of course, I would be even better off if I sold my bonds before rates rise and then buy them back after the price falls. But, if anyone thinks they’re lucky enough to predict and successfully trade their way through every significant change in interest rates and bond prices for the next 20 years, they’ll like the odds of winning the mega-million lottery even better.
These examples illustrate how long-term investors in all asset classes pay the price of the Fed’s bubble-blowing Zero Interest Rate Policy (ZIRP). Fed intervention to manipulate rates lower is merely an illusory scheme which converts real income into capital gains on paper. It’s really a trap and slap in the face to long term investors, because, it only pays if they give up investing, become a speculative market timer, and get lucky enough to cash out at the top to realize their capital gains. Then what? Furthermore, the scheme is inherently temporary. It only works as long as the Fed keeps increasing the amount of counterfeit money it pumps into the markets to keep rates declining and prices rising. That party is clearly over once the no-zone is entered where real rates (after taxes and inflation) drop below zero, like they have been for the last few years. Then, paradoxically, your investment becomes worthless in the long run unless its price drops to a level that generates a positive real yield again.
Several ways to lose money in bonds. 1) Buy bad bonds that have a high risk of default. 2) Buy bad bonds that don't yield enough interest to beat inflation or 3) Sell in a panic when your good bonds are priced below par by a third party pricing service.
Want to make money in bonds? Buy well researched, sound bonds with enough yield to offset a small default risk, and hold to maturity. Price always rises to or above par as the issue seasons and approaches maturity.
Don't invest money you may need tomorrow. Be patient. This is not day trading or options playing or hedging. It's called long term investing. And it works.
"Wake up and get busy, or hit the snooze button?'' First four lines quoted from article.
"That's not just the choice that most investors face every morning, it's what they had to decide recently after Federal Reserve Chairman Ben Bernanke hinted that the central bank will soon end its program of buying bonds to support the market and keep interest rates low.'' Don't believe it when the FED suggests interest rates may soon go higher. The FED has not drove all savers into financial ruin and they will stay the course with low interest rates indefinitely because China owns so much of our debt that if interest rates raised much we wouldn't be able to pay the interest on our national debt.
The "cash is trash" mantra is IDIOTIC! At certain times when asset prices are way over valued (like now) it is advantageous to sell out of these assets and "sit on your cash". For example, during the Great Housing Bubble of 2002 to 2007, these same "Gurus" were saying.... "there is nothing to worry about". After the crash, these SAME Gurus said not to buy houses when the price dropped by 50% or more in many cases.
I was happy to "sit on my cash" during this period and when the bottom fell out of the market, I started buying stocks and houses. My houses are all paid off, rented, producing cashflow and appreciating in value. As I enjoy the cash and also the hedge against inflation that home provide, I am holding for now. As for stocks I am pretty much sold out of all my stocks now and hitting bonds on the "short side" with reverse ETF's. Bonds are going to CRASH with inflation and the high likelyhood of a major credit downgrade coming for the US after printing $3 trillion in "funny money" over the past five years!
So bond and stock investors - sell now and hold onto your cash or sell short on both. You will be able to buy real assets at greatly reduced prices. Gold will also be goo with the US Dollar being devalued and the inflation that is already here in our economy and accelerating too!
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