Rotation Out of High-Grade Bonds Triggered, Bank of America Says

Ten-year Treasury (USGG10YR) yields breaching 2.5 percent signaled the beginning of a wave of outflows from high-grade bond funds, according to Bank of America Corp. (BAC)’s Hans Mikkelsen.

Interest rates simply rose too fast, and for now we think the rotation out of bond funds will contribute more spread widening,” analysts led by Mikkelsen wrote yesterday in a report. If yields continue to increase, “we could see massive outflows from high-grade bond funds and a much more disorderly rotation with significantly wider credit spreads. This scenario remains clearly the biggest risk to high grade this year.”

Investment-grade debt tracked by Bank of America Merrill Lynch has lost more than 6 percent since May 2, wiping out almost a year of gains as concern mounts that the Federal Reserve will pare stimulus measures that bolstered credit markets and pushed yields to a record-low 2.65 percent last month. Relative yields have widened 25 basis points, or 0.25 percentage point, in the same period to a spread of 172.

The U.S. 10-year yield climbed to 2.58 percent at 11:59 a.m. in New York, up from a record-low 1.379 percent set on July 25, 2012. The five-year average is 2.75 percent.

While the Bank of America strategists are “long-term bullish on credit and remain strategically overweight,” they recommend buying credit-default swap protection “until we get comfortable with the coming acceleration of outflows,” according to the report. “The recent sell-off and any further weakness only work to make for more attractive entry points from the perspective of long-term, patient, investors.”

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