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Navel-Gazing Back in Vogue as Bond Traders Flock to Belly

Investors are so convinced nothing will happen in bonds this year that they’re now flocking to a part of the yield curve they’d been avoiding: the belly.

Notes maturing in five to 10 years were among the most-hated last year as investors yanked cash from traditional broad-market funds, favoring shorter-term notes that are less vulnerable to rising yields. Long-term bonds were also outperforming medium-term securities this year until recently as demand from pension funds overwhelmed supply.

Now, those core bond funds that were abandoned in 2013 are back in vogue. This year’s most-popular U.S. debt-focused exchange-traded fund is BlackRock Inc.’s iShares 7-10 Year Treasury Bond ETF, which has received $2.5 billion of inflows, according to data compiled by Bloomberg. Investors also have poured $2.3 billion into the Vanguard Total Bond Market fund, which focuses on a broad index of investment-grade debt, the second most of any fund in the category.

HSBC Holdings Plc strategists say investors should do more of the same because there’s no reason for interest rates to rise anytime soon with economists reducing forecasts for U.S. growth. Yields on benchmark Treasuries have dropped this year, confounding analysts’ expectations that they’d quickly rise as the Federal Reserve curtailed its monthly bond purchases.

Yield Spread

“We further reduce risk by increasing our allocation to fixed income,” HSBC analysts wrote in a June 22 report in which they recommended boosting allocations to U.S. Treasuries maturing in seven to 10 years. “Cash may be king, but fixed income rules.”

Yields between five-to-ten year debt and securities maturing in one-to-three years are collapsing. The gap has shrunk to 2.12 percentage points from 2.52 percentage points in December, which was the most in more than two years, according to Bank of America Merrill Lynch index data. The spread fell to as low as 2.06 percentage points on May 28.

The belly has also been performing in line with the long end, with both gaining a little more than 1 percent since April, Bank of America Merrill Lynch index data show. For all of 2014, five-to-10 year debt has returned 4.1 percent versus 10.6 percent for bonds maturing in 15 years or more.

With volatility plunging to historic lows and Fed Chair Janet Yellen saying last week that she expects rates to stay low for an extended period of time, investors have been growing more comfortable with plain-vanilla bonds. Economists have lowered their predictions for 10-year Treasury yields to 3.07 percent at year-end from a May forecast of 3.25 percent, according to a Bloomberg survey this month.

Without an unexpected jolt to the economy, “we currently see few reasons to load up on risk,” the HSBC strategists wrote.

While other products, like non-traditional bond funds that can go anywhere in the world have also been gaining favor, flows into medium-term bonds show that many investors want to return to the basics. The belly is back.

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