Investors Bound for Shock If Rising Rates Sink Bonds, Cohen Says
Investors who poured more than half a trillion dollars into bond mutual funds since 2007 will experience a market crash when interest rates rise, according to Marilyn Cohen, a Los Angeles money manager.
Cohen lays out a grim scenario in “Surviving the Bond Bear Market” (John Wiley & Sons Inc.), co-written with husband Chris Malburg. Rates will surge if the global economy strengthens or because investors lose faith in governments with growing deficits, said Cohen, whose book came out this month. Standard & Poor’s this week put a “negative” outlook on U.S. credit, citing the risk that leaders will fail to curb debt.
“The baby boomers, who really have been all-in to all kinds of bonds and bond funds since the end of the credit crisis, they’ve never lived through a bear market with skin in the game,” Cohen said in a telephone interview. “It’ll freak people out.”
Fixed-income mutual funds took in net deposits of $645 billion from 2008 through 2010, according to the Washington- based Investment Company Institute. Cohen, who oversees $325 million as chief executive officer of Envision Capital Management Inc., said falling bond prices will lead to a wave of sales, much as the 2008 financial crisis triggered a 46 percent drop in the Standard & Poor’s 500 Index before the U.S. stock- market benchmark bottomed out in March 2009.
Cohen, 61, worked as an equity analyst at William O’Neil & Co. and as a bond broker at Cantor Fitzgerald & Co. before founding her firm, which manages fixed-income portfolios for individuals, 16 years ago. She writes a Forbes Magazine column and a newsletter on bond investing. This is her third book.
‘Bad to Terminal’
Cohen warned in November against California’s general obligation bonds because of the state’s deficits, saying, “The news headlines are going to continue to go from bad to terminal.” Since then, yields have risen to 4.44 percent from 4.09 percent.
Investors can guard against the steepest losses by switching to shorter-term funds, or profit through bearish Treasury bets, Cohen said. A 2 percentage point climb in interest rates over the next 12 months, which she said is possible, could spur price declines of 14 percent in 10-year U.S. Treasuries, according to data compiled by Bloomberg.
“Investors should keep a substantial amount of cash on hand during the nuclear winter to take advantage of the opportunities that inevitably occur,” said Cohen, whose book features a mushroom cloud on its cover.
Not everyone agrees with her thesis.
Muni Market Risk
The risk of municipal bankruptcies is overblown, he said. The average default rate for investment-grade municipal debt in the 10 years after issuance from 1970 through 2009 was 0.06 percent, according to Moody’s Investors Service.
Investors are better off diversifying their holdings among funds with short, intermediate and long-term maturities than putting assets in cash at money-market yields close to zero, Ryon said.
Short-term interest rates might rise more than long-term rates, said Ryon, whose Thornburg Limited Term Municipal Fund averaged 4.1 percent gains in the five years through April 19, beating 89 percent of peers, according to Bloomberg data.
“The steepness of the yield curve makes the cost of insuring against rising rates very expensive,” Ryon said in a phone interview.
The 10-year U.S. Treasury note yielded 3.41 percent yesterday, up from the recent low of 2.38 percent on Oct. 7. Economists predict a rate of 3.91 percent in the fourth quarter, the average of 73 estimates compiled by Bloomberg.
Improvements in indicators such as employment, consumer confidence and housing starts could signal an economic upswing and interest-rate increases, Cohen wrote.
U.S. unemployment declined to 8.8 percent in March from a cyclical peak of 10.1 percent in October 2009. The Consumer Confidence Index decreased to 63.4 in March from 72 in February, the Conference Board said last month.
Federal Reserve Chairman Ben S. Bernanke said earlier this month he expects an increase in commodity prices to create a “transitory” boost in U.S. inflation, and that the central bank would act if he’s proven incorrect.
Interest rates will be driven higher if investors demand better returns from the U.S. government, which owes $14 trillion and faces a deficit estimated at more than $1.6 trillion this year.
China, the largest foreign owner of U.S. Treasury securities, cut its holdings to $1.15 trillion in February from $1.17 trillion in October, according to the Treasury Department.
At worst, China “will stop buying U.S. Treasuries,” Cohen wrote. “At best they will drastically reduce their purchases. Either way, the consequences will be the largest interest-rate hikes in history.”
The Fed, which is purchasing an additional $600 billion in government bonds under a strategy dubbed QE2, may cause “big rumblings” when that program winds down at midyear, Cohen said.
Interest rates could also jump if a state such as Illinois or a city such as Los Angeles defaults on its debt, she said. Los Angeles, she wrote, has a fiscal 2012 deficit equal to about 10 percent of its general-fund expenditures.
“We’ve never been in a sea of red ink like we are in now,” Cohen said. “If things get really worse, we will have some cities and some counties, and certainly in all types of little projects, we’ll see more defaults. Historic numbers have absolutely no relevance.”
Meredith Whitney, the analyst who predicted Citigroup Inc.’s dividend cut, sparked a sell-off in municipal bonds when she told CBS Corp.’s “60 Minutes” in December the market could see at least “50 to 100 sizable defaults.”
Shareholders withdrew a net $43.1 billion from U.S. muni- bond funds from mid-November through April 13, according to the investment institute. Redemptions can force managers to sell securities to raise cash, speeding price declines.
Unlike previous bond bear markets, baby boomers are more invested in fixed-income securities, Cohen said. Of the $4.69 trillion in mutual funds held in retirement accounts as of Dec. 31, one-third was in bond funds or hybrid funds that own stocks and fixed income, according to the institute.
The Barclays Capital U.S. Aggregate Bond Index averaged 6 percent annual returns in the five years through March 31, versus 2.6 percent for the S&P 500.
Investors can benefit from the coming slide by purchasing exchange-traded funds, such as the ProShares UltraShort 20+ Year or iPath U.S. Treasury 10-year Bear ETN, whose prices move inversely to U.S. Treasury bonds, Cohen wrote.
They can buy floating-rate funds such as the Fidelity Floating Rate High Income Fund (FFRHX) or the Oppenheimer Senior Floating Rate Fund that purchase bank loans or corporate bonds whose yields rise along with interest rates, she said.
Another option is short-term ETFs whose holdings expire on a specific date, such as the iShares 2013 S&P AMT-Free Municipal Series or Guggenheim BulletShares 2012 Corporate Bond ETF. (BSCC) Funds with shorter maturities will maintain more value than longer- dated ones if rates climb, she wrote.
Municipal-bond investors should stick to prefunded securities whose principal and interest payments have been set aside by the issuer, minimizing credit risk, she said. She also suggested bonds backed by projects that provide essential services such as sewer and water facilities.
Cohen recommended putting as much as 25 percent of a portfolio in money-market funds, which invest in short-term Treasury bills and commercial paper. Their yields rise along with interest rates.
Instead of buying low-yielding money funds, investors would do better to spread their cash between municipal-bond funds that hold short-term bonds and longer-term ones so they can capture higher yields and lose less principal if interest rates rise steeply, said Thornburg’s Ryon.
Large, well-run bond funds such as Bill Gross’s Pimco Total Return Fund (PTTRX) may be relatively unscathed, Cohen said. The fund had a minus 3 percent of its $236 billion in assets in U.S. government debt and 31 percent in cash last month. It can have a negative position by using derivatives to short, or wager against, the market.
“That’s the smartest guy in the room,” Cohen said. “He’s already in the bomb shelter.”
To contact the reporter on this story: Christopher Palmeri in Los Angeles at firstname.lastname@example.org