Wednesday, December 10, 2014

Checking in on Intermediate-Term Bond Funds

Year-to-date, according to Alliance Bernstein, U.S. stocks are up 14%, compared to a gain of 4.2% for bonds.  From the local market peak on 9/18 to the trough on 10/15, bonds showed their shock absorbing qualities as they declined by only (-1.4%) versus equities at (-7.4%).

It's unclear what fund managers at intermediate-term bond funds are thinking, as the most recent published disclosures are from 9/30, but much has been made of higher cash levels at many funds. Morningstar data shows overall bond fund cash at over 8% of assets, which is alternatively attributed to bond sales, cash inflows, or raising cash for expected redemptions as equity markets continue to rise.

We lean towards the importance of the last factor, especially in light of the growing uncertainty about when and how the Fed plans to raise interest rates.

If bond funds behaved like equity funds, there's no doubt that they would be taking some money off the table because their winners have had long runs and the relative rewards going forward look less inviting.

Investment Grade Corporates issued by financial institutions had a total return of 2.5% in 2006, 11% in 2012, and 8% in 2013, according to Dodge and Cox portfolio managers whose allocations to IGCs is twice as high as their benchmark index.

If there were to be a flight away from bond funds to equity mutual funds ( a sure sign of a market top looking at retail funds), portfolio managers would be challenged because bond markets are relatively thin and inefficient, something we have noted before.

Financial regulation post-crisis has made the dealer market more risky and less profitable.

The favorite financial company issuers in the IGC sector include: Bank of America, JP Morgan Chase, Goldman Sachs, Morgan Stanley and Wells Fargo.  Bank of America, according to Bloomberg data from April 2014, had 1,295 bonds outstanding, but only 53 of these were liquid enough to included in the Barclays US Corporate Index, a popular benchmark.  But, these 53 issues, 4% of total bonds issued, amount for 46% of the dollar amount of Bank of America's debt outstanding. These bonds are over-owned because of their inclusion in the index, and because of their liquidity; investors who chose from the other 1,242 Bank of America issues will be in real trouble if there is a market traffic jam in a bond exodus.

According to BlackRock, market reform in bonds is long overdue, and aside from proposed regulation on mutual fund bond sales our regulators have not seen the improvement in bond markets themselves as something worthy of their serious interest.

No comments: