The Wall Street consensus is that Treasury yields are headed higher in 2013. That’s big news because it could mark the end of a three-decade bull market in bonds.
Strategists expect those higher yields – driven by an upturn in economic growth – to cause bond investors, who after three decades aren’t used to seeing negative returns, to reallocate toward equities. Hence, a “Great Rotation.”
The prospect of higher yields has the government bond market on edge, but it’s also sparked some intense analysis of what could happen to corporate debt markets if rates rise. The rumblings from a few firms in notes to clients are that not everyone is going to come out a winner.
To put it another way, rising rates could wreak serious havoc on corporate debt markets.
BofA credit strategist Hans Mikkelsen describes how it could unfold in what he describes as the “biggest risk” to the market in a note to clients:
In our view, a disorderly rotation out of bonds – characterised by higher interest rates and wider credit spreads – is the biggest risk for investment grade corporate bond investors this year. The key problem is that, with the rise of bond funds and ETFs, individual investors now have a means to trade illiquid corporate bonds in a much more liquid manner.
When interest rates rise and NAVs decline, we are concerned that redemptions will lead to a situation where too many illiquid underlying corporate bonds come out of funds – especially as dealers have little capacity to act as buffer in the new regulatory environment.
Forced selling – and no one to take the other side of the trade.
“But we have never seen a disorderly rotation,” writes Mikkelsen. So, how that sort of scenario would pan out is uncertain.
We have seen two big moves out of bonds spurred by rising interest rates, in 1994 and in 1999, but the picture is radically different now, thanks to the rise of mutual funds in the corporate bond market.
Photo: Federal Reserve Flow of Funds, BofA Merrill Lynch Global Research
Mutual funds and ETFs, whose investors are typically going to head for the exits if they observe negative returns, have accounted for a big portion of the buying in recent years as investors across the spectrum have searched for yield. Thus, a decent share of the market is exposed to forced selling by these funds.
In comparing today’s set-up to 1994 and 1999, Mikkelsen writes:
However, what is different this time is that, following continued declining interest rates and quantitative easing, bond fund assets under management have expanded significantly.
Moreover, the share of corporate bonds in mutual fund fixed income assets has increased to 42% from 24% in 1994 and 31% in 1999. Hence, mutual funds and ETFs now own 19% of the corporate bond market (high grade and high yield), up sharply from 9% and 10% in 1994 and 1999, respectively.
Thus, if we were to experience outflows from bond funds of the magnitude seen in 1994 and 1999, the impact on corporate bonds this time would be much more severe.
On top of the illiquid nature of the instruments being used to trade corporate bonds and the growing share of the market held by those instruments, there may be another massive, secular headwind for credit markets to contend with if things really pan out for the American economy.
The “Great Rotation” itself.
Huge January flows into equity funds weren’t a sign of the Rotation, but it still exists as a prediction for the latter half of 2013 or 2014 if U.S. economic growth picks up as market economists expect.
So, here is what the “Great Rotation” looks like from the credit perspective, according to Mikkelsen:
Moreover, following the extended declines in interest rates, and associated outsized fixed income total returns, households now hold more than 13% of their financial assets in fixed income – at the upper end of the historical range and sharply above the low of 8% we saw more than 30-years ago in the early 1980s before interest rates began their secular decline.
This higher fixed income allocation to us is a direct result of the extended environment of declining interest rates – when interest rates start increasing, we look for households to reduce allocations to fixed income. This, despite the underlying bond friendly demographics.
Of course households’ percentage allocation to fixed income automatically declines when stock prices increase – but there is reason to suspect that households will play a more active role in rebalancing out of bonds, into stocks as interest rates increase.
Combine the “Great Rotation” with a corporate bond market uniquely vulnerable to rising interest rates and credit markets may have a tough go of it this year or next.
Mikkelsen thinks 10-year Treasury yields would have to keep rising past 2.5 per cent and on toward 3 per cent in 2013 in order for a sell-off in credit like the one described above to occur.
“Timing is obviously also important,” he writes, “as the disorderly scenario requires a fairly rapid, as opposed to slow and drawn out, increase in rates.”
Citi strategist Stephen Antczak, on the other hand, writes that if 10-year yields rise “anywhere near what our economists expect (again, 2.5% by year end),” that total returns in bond funds could be negative, which would create a forced selling situation.
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