Bond market headlines are concerning these days. Yields are rising, prices are falling and investors are taking their money out of bond funds at a record pace. The question now is: Where is this money headed?
Bloomberg News reported that more than $60-billion (U.S.) was withdrawn from U.S. bond funds in June, a record high. Pacific Investment Management Co. – or PIMCO, home to the world's largest bond fund – was hit with $9.9-billion of redemptions last month from its Total Return Fund, according to Morningstar.
The move away from bonds follows the Federal Reserve's recent warning that it intends to wind down its bond-buying stimulus program later this year if the economy continues to improve, ending so-called quantitative easing (or QE) in 2014. More importantly, though, the redemptions follow bond losses after bond yields began to rise sharply in May. The yield on the 10-year U.S. Treasury bond rose as high as 2.6 per cent by late June from 1.63 per cent in early May. As yields rise, bond prices fall.
To be sure, redemptions are a mere hiccup compared to the size of bond holdings. For example, the PIMCO fund has assets of $268-billion, meaning that the withdrawals accounted for less than 4 per cent of the fund. Overall bond redemptions were less than 2 per cent of total assets.
Nevertheless, the redemptions mark a sharp reversal and could mean rough days ahead for bonds if the trend continues. Bloomberg News pointed out that safety-conscious retail investors have put about $1-trillion in bond funds since the start of 2009.
That could mean good things for stocks if the money flowing out of bonds heads toward equities – a theme that showed a lot of promise near the start of the year but has since sputtered. This is the idea behind the "Great Rotation" theme, outlined by strategists at Bank of America, among others.
Vincent Delisle, a strategist at Bank of Nova Scotia, picked up on this theme in a note on Thursday, adding: "In the near term, QE tapering scenarios will likely create volatility that could stall equity flows. Still, negative bond returns and sustained U.S. macro improvements should eventually benefit equity flows, igniting the long-awaited 'Great Rotation.'
The other idea is that investors could be getting ahead of themselves – fleeing bonds at the first warning shot from the Fed, even though the end of stimulus is not assured. While the U.S. economy has been showing encouraging signs, it is still prone to disappoint. Notably, economic growth in first quarter was revised down to just 1.8 per cent from an earlier estimate of 2.4 per cent. And the ISM non-manufacturing index came in at 52.2 in June, considerably shy of economists' expectations.
Some bond investors believe the worst is over for bonds, and that the market has overreacted. Bill Gross, managing director at PIMCO, argues that the Fed is being too optimistic in its economic projections and that economic growth is going to disappoint. That, combined with an inflation rate that is below the Fed's target, means that the yield on the 10-year Treasury bond should be closer to 2.2 per cent.
In other words, buying now should deliver capital gains to bond investors as the market gets back in line with reality.