A Perfect Storm- The misperceived safety of fixed income markets and bond funds

Ben Bernanke’s recent statements that the end of the $85 billion per month spigot of cash that the Fed is contributing to the bond market is near, has sent bond and equity markets to some of their most volatile levels since the Credit Crisis.  Indeed, long term interest rates endured a 100 basis point increase in the aftermath of Mr. Bernanke’s comments.

The resulting market volatility has driven bond fund managers to apologize to investors for their fund’s recent losses conceding that they did not anticipate that the 10-year Treasury yield would rise above 2.5%.[1]

Not surprisingly and despite these recent losses, these same bond fund managers are urging investors not to panic and to stay the course.

But if history is any indicator, investors should not blindly follow the advice of fund managers who have a vested interest in keeping their funds’ assets to a maximum.

The simple and undeniable truth is this: basic economic principals provide that interest rates cannot perpetually remain at all time lows.  And the Fed certainly cannot continue to dump $85 billion into the bond market to help keep those rates at all-time lows.

So why, then, are bond fund managers, who are supposed to be authorities on bond markets, so surprised and unprepared for this sudden jump in long term interest rates?

Answer: THEY SHOULDN’T BE.

The fact that these managers were unprepared for this rapid increase in interest rates represents the culmination of a complete shift in how investors perceive the relative safety of fixed income investments.  The market’s reaction to this recent jump in interest rates coupled with bond fund managers’ total lack of preparedness for such a jump should serve as a red flag for both investors and brokers who have exposure to bond markets.

One of the contributing reasons for this shift in perception directly relates to the fallout from the Credit Crisis. In the thousands of lawsuits that riddled the financial industry in its aftermath, investors commonly argued that their brokerage firm and/or broker misallocated funds by creating a portfolio with too much equity exposure.  As the DOW Jones Industrial Average lost half of its value at the height of the 2008-2009 financial meltdown, investors argued that their portfolios should have been more heavily allocated in fixed income, which could have served as a hedge against losses realized through too much equity exposure.  This argument resonated with elderly investors in particular.

Now, five years after the Credit Crisis, droves of investors have reallocated to more fixed income heavy portfolios due to a combination of the perceived safety of fixed income and the yield such a portfolio can generate.  Most of these investors are exposed to fixed income through mutual funds and other alternative investments and are totally unfamiliar with the durational risk of these funds.   Bond funds heavily invested in long-term debt experience greater short term losses when interest rates rise.

Accordingly, investors exposed to longer term debt experienced significant short term losses following this recent rise in interest rates.  These investors learned the hard way that bond-heavy portfolios are not the stalwart of safety as has been perceived.

Such short term losses have put investors who are unfamiliar with the risks associated with fixed income investment and their brokers in a perilous position.  On the one hand, you have an investor who may not have considered the extent of the short term risk exposure associated with bonds and bond funds.  As a result, the investment he or she thought was safe, suddenly experiences a significant decline not thought possible.

On the other hand, you have a broker with a client seeking a return combined with relative safety in an environment with all time low interest rates and equities trading near all time highs.  That is, a circumstance where both bonds and equities have the prospect of experiencing significant losses simultaneously despite these markets traditionally maintaining an inverted relationship.

Broker-dealers are taking notice of this risky environment.  For example, UBS has begun requiring its investors positioned in fixed income to change their investment objective to allow for more risk to insulate itself from future liability.

The bottom line.  Brokers need to carefully evaluate their clients’ exposure to the bond markets and make certain they understand the risks associated with fixed income investment (duration risk, especially).  Moreover, brokers need to ensure their clients’ “sleep well money” is subject to minimal bond and equity market risk; because if brokers’ clients are not prepared for a wild ride in the bond markets, they will run the risk of creating liability exposure not seen since the Credit Crisis.