Thursday, February 7, 2013

Severe Danger Looming In Corporate Bonds?

Jeff Cox of CNBC reports, 'Severe' Danger Looming In Corporate Bonds:
A jump in interest rates could spark an unruly exit from the $12 trillion corporate bond market, according to a new analysis.

Investors have been flocking to the relative safety of corporate and government debt while interest rates have stayed low and stock market tensions have run high.

But an expected shift out of fixed income - particularly top-quality investment grade - and into stocks coupled with a commensurate rise in interest rates and a much more easily traded corporate debt market could send tremors through the space, Bank of America Merrill Lynch said. (Read More: 'Easy Money' Will Help Stocks for Foreseeable Future: Roubini)

"A disorderly rotation out of bonds - characterized by higher interest rates and wider credit spreads - is the biggest risk for investment grade corporate bond investors this year," Hans Mikkelsen, credit strategist at BofA, said in a note to clients. "However, history offers little guidance about how much of an increase in interest rates would prompt such disorderly scenario and how it would play out."

Some indicators about this move, though, could be flashing now.

Stocks turned in their best January in 16 years to start 2013 and Treasury yields rose in unison. (Read More: Better Enjoy the Market Rally While You Can: Marc Faber)

The current 10-year yield at 2.02 percent does not meet Mikkelsen's criteria for what would trigger a "disorderly rotation" from investment grade corporates, but it is moving in that direction. The benchmark note began the year at 1.86 percent.

Mikkelsen estimates that a 2.5 percent yield would lead to what he would consider an orderly move out of the market, but a continued trek higher past 3.0 percent would be the game-changer.

BofA is not alone in its aversion to fixed income - Wells Fargo recently cautioned its clients about fixed income amid dangers from rising rates, and advised shifting 5 percent of their bond positions into stocks.

Because the corporate bond landscape has changed so much, history offers little guide about what could happen in a disorderly rotation. However, conditions in 1994 and 1999 are two periods that saw significant interest rate changes and corresponding outflows from the market.

Those cases saw investors pull about 10 percent of total assets out of corporate bonds. But even then, the parallels are different to draw primarily because of the different vehicles investors use to buy company debt.

In those days mutual funds were a bit player in the space, and exchange-traded funds even less.

But fixed income flows have surged and occupy huge parts of the fund industry, with $3.43 trillion in bond mutual funds, compared to nearly $6 trillion in equity funds.

Bonds now are the biggest player in the $1.4 trillion ETF market with $238 billion of total assets, outpacing even large-cap stocks, which have $227 billion under management, according to industry tracker XTF.

Corporate bonds had long been an illiquid asset - difficult to trade as investors usually either held bonds to duration or until the debt was called. But because ETFs trade like stocks and generally carry lower fees than mutual funds, they have changed the way the market operates. (Read More: Money Pouring Into Stocks 'Is Usually a Negative Sign')

"The key problem is that, with the rise of bond funds and ETFs, individual investors now have a means to trade illiquid corporate bonds in a much more liquid manner," Mikkelsen said. "When interest rates rise and (net asset values) decline, we are concerned that redemptions will lead to a situation where too many illiquid underlying corporate bonds come out of funds - especially as dealers have little capacity to act as buffer in the new regulatory environment."

Corporate bonds are now 42 percent of mutual fund assets, compared to 24 percent in 1994 and 31 percent in 1999, while mutual funds and ETFs combine own nearly one-fifth of the entire corporate bond market, including high yield bonds.

Households, meanwhile, have shifted assets as well, with 13 percent of their portfolios consisting of bonds, according to BofA figures.

"Thus, if we were to experience outflows from bond funds of the magnitude seen in 1994 and 1999, the impact on corporate bonds this time would be much more severe," Mikkelsen said. "There is reason to suspect that households will play a more active role in rebalancing out of bonds, into stocks as interest rates increase."
Indeed, retail investors heavily invested in these corporate bond mutual funds will get crushed if there is a major backup in yields.

But it's not just retail investors that risk experiencing losses. I'm also worried about institutions like pension funds and insurance companies that have been plowing into corporate bonds after the 2008 crisis. They made great returns but the big "beta" trade is now over and many who are still overweight corps and junk bonds in search of higher yields risk suffering huge losses if interest rates spike this year.

Yesterday, had lunch with a former fixed income trader and salesman and we spoke about the illiquidity in the corporate bond market during the 2008 crisis. "When the markets seized, traders were bidding way below par value. It was a bloodbath and many corporate and junk bonds weren't even trading. Convertible bond arbitrage strategies got crushed."

Later in the afternoon, spoke to a top fixed income portfolio manager at the Caisse who expressed concerns over the "leverage in the steepner trade in US Treasuries." He said many institutions are playing the carry between the 30-year bonds and 5 and 7-year bonds, rolling down the yield curve to squeeze out returns.

"The 30-5 year spread is now 234 basis points. Bond traders playing the steepner are getting excellent carry. But many are putting leverage on this trade, playing with fire. It's as if they're betting the Fed won't raise rates or stop asset repurchases or they're betting on easing, which is crazy. If there is a 50 basis point 'flattening' of this spread, the risks of this carry trade will rise considerably and unwinding it will prove extremely costly."

He rightly pointed out that the bond market reacts way ahead of the Fed and he agreed with me that the US economy will likely surprise to the upside, placing more pressure on interest rates to rise. We also spoke briefly about Japan's Great Rotation and told me he's more comfortable shorting the yen than JGBs.

On Europe, he told me a lot of fixed income portfolio managers who took a "Risk Off" approach in 2012 fearing the end of the world got clobbered as spreads tightened considerably in periphery sovereign debt. True, some brave and smart investors made a killing while others lost their job.

Finally, it's important to note that not everyone is convinced there is a bubble in bonds or junk bonds. Some point to historic low default rates, record corporate cash flows and profits while others say central banks will limit the damage if the bond market seizes up. Don't know but would definitely review the leverage and exposures in bond trades if I was a board of director at a large pension fund.

As far as interviews, Jonathan Krinsky, chief market technical strategist at Miller Tabak, talked to Yahoo's Matt Nesto about how junk bonds are warning that stocks are about to fall. I don't buy it. Think it's just a normal rotation out of junk bonds based on risk/ reward considerations. Moreover, as everyone waits for the "big pullback" to jump into stocks, think they will be sorely disappointed. The fact remains this bull market gets no respect.

And below, Dominic Konstam, the global head of rates research at Deutsche Bank AG, talks about the outlook for the U.S. bond market and Federal Reserve monetary policy. He speaks with Tom Keene, Sara Eisen and Paul Sweeney on Bloomberg Television's "Surveillance."