A $113 Billion Bet High-Grade Debt Thrives on Slowdown

There’s about $113 billion that seems to be betting on a growth slowdown instead of higher interest rates.

That’s how much mutual-fund investors have poured into investment-grade bond funds this year -- more than they’ve deployed in equities, junk-rated securities or money-market funds, according to data compiled by Wells Fargo & Co. Investors have been attracted to the debt’s relatively safe credit quality, fueling gains of 6.8 percent for highly rated U.S. company bonds in 2014.

Here’s the catch: Yields on investment-grade corporate bonds have dropped to within half a percentage point of their all-time low and are now almost as sensitive as they’ve ever been to interest-rate increases.

The trade is questionable to some, given the Federal Reserve has said it plans to lift its benchmark rate next year from near zero, where it’s been since the end of 2008. Analysts forecast the U.S. economy is strengthening, and these bond buyers are at risk of losing when borrowing costs rise.

“People have been lulled to sleep from 30 years of positive returns,” William Eigen, head of the absolute return and opportunistic fixed-income group at J.P. Morgan Asset Management, said at a press briefing yesterday at the firm’s New York office. “You have to be more careful today than ever before in history.”

Yields Drop

Mutual-fund investors have plowed more than $3 billion into investment-grade bonds in each of the past eight weeks, adding $4.2 billion to their holdings in the week ended Nov. 12, Wells Fargo data show. There have been $20 billion of withdrawals from junk-bond funds and $58.8 billion of deposits into stock funds this year.

Yields on investment-grade corporate bonds have shrunk to 3.14 percent from 3.37 percent at the end of last year, according to a Bank of America Merrill Lynch index that includes debt of Apple Inc. and Verizon Communications Inc. Those on junk bonds, which are less sensitive to interest-rate moves, have held at about 6.4 percent.

Of course, Wall Street has been ratcheting back its expectations for how much interest rates can really rise in the face of lower oil prices, slowing growth in China and the threat of deflation in Europe. Credit investors didn’t name rising borrowing costs as one of their top three concerns in a November survey by Bank of America Corp.

Investor Concerns

“More investors are now concerned about each of China, oil prices and slow recovery than the upside risk of higher interest rates,” Bank of America analysts wrote in a Nov. 10 note.

As investors worry more about other threats, the debt’s interest-rate risk has climbed. Its effective duration, a gauge of how susceptible the notes are to losses when borrowing costs rise, is almost equal to the highest ever, and 10 percent above the decade-long average.

The bond rout that took place during two months last year - - prompted by concerns that the end of the Fed’s securities purchases would lead to a rapid rise in rates -- serves as a reminder of potential losses.

Investment-grade corporate securities plunged 5 percent in May and June 2013, their worst two-month performance since the depths of the 2008 financial crisis, as yields on 10-year Treasuries climbed 0.8 percentage point, according to Bank of America Merrill Lynch index data.

If the global economy keeps bumping along without a dramatic surge in growth, that $113 billion may emerge relatively unscathed or even prosper. However, if the outlook picks up, these notes may be among the hardest hit.

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