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Bond Investors Still Playing Chicken With the Fed and Rates

At midyear 2014, taxable-bond CEF categories like bank loan and high yield--which had strong runs last year--have had muted success, while preferred stock leads the pack.

Sumit Desai, CFA, 07/04/2014

The rocky bond markets of 2013 gave rise to two memorable phrases. The Federal Reserve's "taper tantrum" of 2013 caused 10-year Treasury bond yields to spike to almost 3% from 1.7% by the end of 2013. This move in rates led many to expect a "Great Rotation," reflecting expectations that investors would move out of bonds after a 30-year rally and rotate back into stocks. With the Fed easing off its bond-buying program and rates still low on a historical basis, it was easy to expect the upward march in rates to continue in 2014, and assets flowed into less rate-sensitive bond categories, including bank loans and nontraditional bonds.

But like many times when buzzwords fill the airwaves and a strong consensus exists in a market, the opposite occurred in the first half of 2014. Ten-year Treasury yields started 2014 at 3% but surprised many by dropping to 2.5% as of June 30, even as the Fed reduced its monthly purchases of mortgage-backed securities to $15 billion from $40 billion and longer-dated Treasury securities to $20 billion from $45 billion over the past six months.

It's difficult to pinpoint the exact reason rates have declined so far this year, but there were many factors driving the move. Following a remarkable 2013 for equities, many pension funds and other investors rebalanced portfolios back toward longer-term bonds in order to more closely match their long-term obligations. Further, while rates remain low in the United States, they are even lower in Europe and other regions, making U.S. bonds once again the go-to for investors seeking safety and income. Turmoil in the Middle East and concerns over Chinese growth have also caused a flight to safety. And while the Fed has tapered its bond purchases, it still hasn't raised its key federal-funds rate and has publicly stated it won't do so for a "considerable time" after its asset-purchase program has completed. So for now, investors continue to play chicken with the Fed and rates.

The table below provides a view of how various closed-end fund categories performed through the first half of 2014, ranked by net asset value return. As you can see, some of the top-performing categories for the year to date, such as long-term bonds and emerging markets, were those that performed the worst in 2013. While discounts widened for much of 2013, share-price returns have exceeded NAV returns, and discounts have narrowed, too.

The preferred stock category is having the best 2014 so far and returned 14.3% on average. As you can see in the table below, much of what drove performance in this category was a strong performance from a suite of similarly run John Hancock funds that all earned Morningstar Analyst Ratings of Bronze. These funds' holdings are long-term in nature and thus highly sensitive to interest rates. For that reason, it's not too surprising to see strong performance so far this year, especially after this category suffered losses in 2013. 

High-yield bonds and bank loans were the top-performing categories in this group last year, but they've had more muted success so far in 2014. High-yield bonds returned 6% on a NAV basis, even as many consider the space overheated as spreads look tight on a historic basis. Bank loans, too, are near the bottom of the category after a roaring 2013. Last year, more than $60 billion flowed into the open-end bank-loan category, which helped drive capital appreciation for these funds. However, the tide has turned so far in 2014, and investors, perhaps skeptical of rising rate prognostications, have started to take money out of bank-loan funds. Some of the relatively worst-performing funds in this group include Silver-rated Eaton Vance Floating Rate Income EFT, which generally has a high-quality bias. Riskier assets rallied in 2014, leaving this conservative fund behind. And because of liquidity issues across bank-loan trading channels, Eaton Vance's more-liquid holdings likely sold off faster than riskier, nonliquid loans when flows turned earlier this year.

It's safe to say the interest-rate decline during the first half of 2014 caught many investors by surprise. That said, bond yields are low by historical standards, and there are still many forces that may cause rates to rise in the future.

Sumit Desai, CFA is a senior stock analyst with Morningstar.

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