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Bond Love Endures for Investors Unconvinced Rally’s Over

PIMCO Co-CIO Bill Gross
Co-Chief Investment Officer of Pacific Investment Management Co. Bill Gross. Photographer: Scott Eells/Bloomberg

Bill Gross, the world’s largest fixed-income manager, says the bull market for bonds may have ended last month. Investors are staying put.

Four years into the biggest rally in U.S. stocks since 2000, bond mutual funds are attracting more money than their equity counterparts. After at least three warnings from Gross that the fixed-income market has peaked, there’s no evidence of what strategists including Michael Hartnett of Bank of America Corp. have predicted would be a ``great rotation'' out of fixed income into stocks.

“For the past 25 years, you’ve seen the stable decline of interest rates and a level of comfort that bonds are the stable asset,” Rick Rieder, New York-based BlackRock Inc.’s co-head of fixed income in the Americas, said in an interview. “Money will still flow into bond funds for the next couple of years because of the tremendous need for income by an aging population.”

Investors are piling into fixed income as aggregate mutual-fund returns drop to a two-year low and money managers from Gross to DoubleLine Capital LP’s Jeffrey Gundlach say that bond-market yields are shrinking. Berkshire Hathaway Inc.’s Warren Buffett said this month that he “feels sorry” for fixed-income investors and Bridgewater Associates LP’s Ray Dalio has called bonds a “terrible” investment. Investors addicted to bonds have missed a more than doubling of stock prices since 2009.

Gross’s Warning

Gross, co-chief investment officer of Pacific Investment Management Co., said on May 10 that the bull market for bonds, including Treasuries, corporate debt and mortgages, probably ended in the last week of April as yields reached a low and prices peaked. In March 2010, he said bonds may have seen their best days and then eight months later that a renewal of asset purchases by the U.S. Federal Reserve may signify an end to the three-decade-long rally.

Since his first warning, investors have poured about $800 billion into bond mutual funds and exchange-traded funds industrywide. Pimco, which manages $2.04 trillion, had record deposits during the first quarter.

The extra yield over the safest government-backed debt that investors demand to hold investment-grade corporate, government and securitized debt fell to 53 basis points on April 29, the day Gross said the bull market in bonds “likely ended,” from 78 basis points a year earlier, according to the Bank of America Merrill Lynch Global Bond index. The narrowing gap, which stood at 53 basis points on May 17, shows that investors are willing to pay more for bonds. Spreads fell to 52 basis points on May 3, the least since July 2010.

Bonds Trail

The Barclays U.S. Aggregate Index, among the most widely used fixed-income benchmarks, advanced 0.01 percent this year through May 17. The average intermediate-term bond fund in the U.S. rose 0.3 percent in the three months ended March 31, the worst quarterly performance since the fourth quarter of 2010, according to Chicago-based Morningstar Inc.

The Standard & Poor’s 500 Index, by contrast, has surged 17 percent this year and has increased 146 percent since a low on March 9, 2009. That’s the biggest rally since the 50 months through March 27, 2000, when the index advanced 149 percent, according to data compiled by Bloomberg.

BlackRock, the world’s biggest money manager with $3.94 trillion in assets, and Western Asset Management Co., a unit of Legg Mason Inc., said investors will keep their money in bond funds for at least the next two years as they continue to think of them as a safe haven. After getting burned by equities in 2008, when the S&P 500 plunged 38 percent, investors have been slow to warm up to stock funds again. In the four years ended 2012, investors pulled $307 billion from equity mutual funds in the U.S., according to the Washington-based Investment Company Institute.

Irrational ‘Triskaidekaphobia’

“It’s basic human psychology if you go through a year like 2008 it will take a while to get comfortable with equities again,” said Lee Spelman, head of U.S. equity client portfolio managers at New York-based J.P. Morgan Asset Management, who has given a presentation to clients entitled ‘Triskaidekaphobia,’ comparing the irrational fear of the number 13 to the fear of the equity markets. “Every year for the last four years, people have said the bond trade is over and yet it keeps going.”

Larry Swedroe, a 61-year-old managing principal at the BAM Alliance, a partnership of about 145 registered investment advisory firms, said he has about 70 percent of his portfolio invested in municipal and taxable bonds and isn’t going to adjust it.

Dampening Risk

“I don’t want to shift from very safe bonds whose purpose is to dampen risk of the overall portfolio, protecting me in years like 2008 so I don’t get hammered,” said Swedroe, who’s based in St. Louis. “You just have to live with low interest rates and think of that as an insurance premium against those event risks.”

Equity mutual funds attracted an estimated $71 billion this year through May 8, according to data from ICI. The deposits haven’t come at the expense of bond mutual funds, which received an estimated $86.3 billion. Investors are pulling money out of money-market funds, which had redemptions of $101 billion in the first quarter, ICI data show.

BlackRock said its clients won’t exit core bond funds and will probably put new money into shorter-duration and more flexible bond strategies. Western Asset, with $460 billion under management, said the central bank’s accommodative policies will help to keep interest rates from going above 2.5 percent, and its stock affiliate, ClearBridge Investments, said without a meaningful change in rates there won’t be a big transition to stocks. Pimco’s parent Allianz SE said it doesn’t see any evidence of a so-called great rotation out of bonds.

No Rotation

“Because money-market outflows are the source of equity inflows, there is no rotation from bonds into equities visible so far,” Dieter Wemmer, chief financial officer of Allianz, a Munich-based insurer, said May 15 in a presentation to analysts.

At Newport Beach, California-based Pimco, investors deposited about $52 billion into its products in the first quarter, an 84 percent jump from a year earlier, and the most client deposits ever in a quarter, according to the Allianz presentation. Pimco, which has more than 90 percent of its assets in bond-related strategies, added a stock-fund unit as it anticipated diminishing returns from the fixed-income market.

U.S. bond mutual funds more than doubled their assets to $3.5 trillion as of March 31 from $1.56 trillion before the financial crisis six years earlier, according to TrimTabs Investment Research in Sausalito, California. That compares with an increase of only 6.5 percent for U.S. stock mutual funds to $6.5 trillion.

‘Large Disconnect’

“Despite numerous stock markets records, the excitement that has accompanied the markets’ solid returns has not, and is not, anxiety free for investors,” Mohamed El-Erian, Pimco’s chief executive officer and co-chief investment officer with Gross, said in an e-mail. “This is a reflection of the large disconnect between the exuberance of markets and the more sluggish real economy, the experimental policies of a growing set of central banks, political dysfunction and pockets of geo-political risk.”

The bond market is entering a “12-month period of time ahead in which, combined, Treasury, corporate and high yields don’t move much,” Gross said in a May 16 Bloomberg Television interview. He said May 10 that fixed-income returns will probably be in the range of 2 percent to 3 percent.

Pimco doesn’t expect the end of the 30-year rally to be like the drop in 1994, when the Federal Reserve raised interest rates more than forecast and Treasuries lost 3.35 percent. The firm is advising clients to consider emerging-market debt and strategies that are unconstrained by maturity, credit quality or region.

Dalio, Gundlach

Bridgewater’s Dalio told CNBC on May 17 that central bank asset purchases have made cash and bonds poor investments. DoubleLine’s Gundlach said in April he expects broad fixed-income benchmarks to return just more than 1 percent in the 12 months ending July. Buffett said at Berkshire Hathaway’s May 4 shareholder meeting he sympathizes with people who stuck with bonds amid low interest rates.

Deleveraging by developed economies coupled with central bank purchases means there will be a limited supply of bonds available to investors, which will keep rates low for at least five years, said BlackRock’s Rieder.

Only a dramatic change in global growth, inflation or central bank policies would result in investors pulling out of bond funds in a big way, said Steve Walsh, co-chief investment officer for Pasadena, California-based Western Asset. That isn’t likely to happen as the Fed has said it will continue quantitative easing, or bond purchases to stimulate the economy, until mid-2015 or 2016, he said.

Fed policy makers will meet on June 18-19 and Fed Bank of Philadelphia President Charles Plosser reiterated his view on May 16 that the central bank should begin to curtail bond purchases this year.

‘Cumulative Fatigue’

A gradual increase in interest rates correlated to a better economic environment will be beneficial for stock deposits, said Vinay Nadkarni, head of financial-intermediary distribution at New York-based equity manager ClearBridge Investments, which has $68.1 billion in assets. ClearBridge had the most net deposits in the first quarter since it was acquired by Legg Mason in 2005, which are coming mostly from investors moving out of cash, Nadkarni said.

“There’s the cumulative fatigue of the trillion on corporate balance sheets and in retail money-market funds earning zero,” he said. “Fixed income doesn’t have to lose for us to win.”

A trigger for money flowing into stock funds from money-market funds as well as bond funds may be from investors who buy dividend-paying stocks for the yield component and then are pleasantly surprised by the capital appreciation, said Brian Hogan, president of the equity group at Boston-based Fidelity Investments, the second-biggest U.S. mutual-fund company.

“The last 30 years have been a very favorable environment for fixed-income investing,” Hogan said. “Some of the macro concerns still persist, so I think the backdrop we’ve seen in the fixed-income landscape has created an environment where folks are very comfortable with their fixed-income exposure.”

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