Bond Funds With $200 Billion in Cash Prep for Redemptions

Given the option of losing out on 10 percent-plus returns in a resurgent rally or being the last one standing in a tanking market, bond-fund managers have voted: They’re going with option #1.

Taxable-bond funds are keeping more than $200 billion of cash or equivalents on hand, according to data from the Investment Company Institute. That’s equal to 7.6 percent of their assets at the end of March, up from 3 percent in 2010.

It’s also about three times the amount needed to meet the worst month of outflows, according to Brian Reid, ICI’s chief economist.

So, why such an increase?

The bond business has changed dramatically since the financial crisis, making it harder to get in and out of positions as Wall Street banks cut thousands of employees and shrink their balance sheets.

If many debt investors try to exit at once, the market will probably become much more volatile, in large part because dealers aren’t as willing to cushion price moves with their own money the way they used to.

Bond funds have responded by boosting cash reserves so they can meet redemptions without having to immediately sell at a huge loss. They’re also investing more in derivatives, both to hedge against rising rates (long-anticipated, but still hasn’t really happened), and to quickly make bets on less-liquid parts of the credit markets.

Derivative Bets

Case in point: Investors boosted bullish wagers on a liquid index of swaps tied to U.S. high-grade corporate debt by $1.4 billion in the week ended May 2, to $26.2 billion, data compiled by Bank of America Corp. analysts show. Often, managers will hold cash against such positions to compensate for the fact that they may be on the hook to make payments if their bets go awry.

Also, more investors have cycled into shorter-term debt as they wait for benchmark yields to rise, since the Federal Reserve is reducing the pace of its bond buying.

Funds have been punished for being so conservative. The broad U.S. bond market has gained 3.2 percent this year, the best return for the period since 2010, according to Bank of America Merrill Lynch index data. And bonds maturing in 15 years or more have handed investors 10.7 percent.

Meanwhile, non-traditional bond funds, which give managers the flexibility to decide how they want to invest, are up 1.7 percent through yesterday, according to data compiled by Morningstar Inc.

The question is, will bond investors capitulate to the sixth year of the Fed’s easy-money policies and dive back into the market -- or will they continue giving up returns so they can sleep at night?

Before it's here, it's on the Bloomberg Terminal.