Everywhere bond-fund investors look, reasons to fear seem to be lurking.
After decades of dropping interest rates led to strong and steady returns for bond funds, conditions seem to be massing in the opposite direction. The Federal Reserve raised short-term rates last month, the third time it's done so since December. It's also planning to pare the vast trove of bonds it built up to keep rates low following the financial crisis.
Even words from way across the Atlantic are rattling the U.S. bond market. The European Central Bank said a couple weeks ago that it could trim stimulus efforts if that region's economy keeps strengthening. That could send European rates higher, luring money back into European bonds and out of Treasurys.
Anticipating such a shift, investors pushed Treasury prices lower over the past two weeks, helping to send the yield on the 10-year T-note up to 2.35 per cent from 2.13 per cent.
Rick Rieder, chief investment officer of global fixed income at BlackRock, which manages $1.6 trillion in bonds, says the bond market is indeed going through a change. But he cautions investors not to get carried away.
Demand for bonds has remained strong this year, and $170 billion flowed into bond funds through the first five months of this year, nearly double last year's pace at the same point, according to the Investment Company Institute. That deep hunger for income, a result of an aging population looking to retire, should help keep the upturn for rates moderate, Rieder says.
Answers have been edited for length and clarity.
Q: Many voices are calling this a big inflection point for the bond market. How momentous is this right now?
A: I would agree that things are changing, but I don't think they're momentous. Rates are going to move moderately higher. There's a demand for income in the world driven by demographics that's generationally historic, and whenever rates back up, you see this tremendous buying come in (which in turn lessens the upward pressure on rates).
The only thing that's different than historically is the interest-rate sensitivity of the market is higher. Small moves in rates can lead to decent-sized moves in price.
Q: So many factors seem to be pushing the U.S. bond market, not just the Fed raising rates.
A: Long-end interest rates are influenced more by the European Central Bank and the Bank of Japan than the Fed, ironically. When Europe takes some of the pressure off interest rates, it's so dramatically large, it allows the long end of our interest rates to move out.
Q: What about the Fed paring back its $4.5 trillion in bond investments? Will that have a bigger effect on the market than any rate increases?
A: They're starting very, very slowly. The reduction of the balance sheet, this year, is a smaller influence than a rate move. They're talking about $10 billion a month, which relative to the size of fixed-income markets is tiny.
But in the next two years, the pace is increasing at the same time that the federal borrowing level is changing. Supply and demand (for Treasurys) come much more in balance, which means rates can move higher.
Q: How much higher?
A: We think 2.50 per cent to 2.75 per cent for the 10-year Treasury this year. You can move to 3.25 per cent next year.
Q: Inflation has also remained low for a long time now, and it sounds like you think it can stay that way for a while, which would moderate rising rates.
A: One of the reasons why this is an inflection point but not momentous is we're witnessing something that's truly historic. First, what drove the volatility in inflation over the last 25 to 30 years was energy and oil. We're witnessing a greater equilibrium in oil, and OPEC doesn't drive the price any more. There are so many other players.
Second is housing prices. You go back 20 or 30 years, and the Baby Boomers were driving the environment for housing prices, and you don't see that now. Third, technology is pressing down on inflation like nobody's ever seen before. You saw it in the last (Consumer Price Index) report. From apparel to transportation, i.e. the Uber effect, you're creating this unbelievable pressure on potential inflation.
Inflation will go higher, but we're going to be in this range of in and around 2 per cent inflation.
Q: So what can investors expect from their bond funds? Certainly not the big returns they got from earlier years. How likely are losses?
A: You can still generate good fixed-income returns, but you have to do it differently than historically. In the BlackRock Strategic Income Opportunities fund, you can still do a positive 4 to 5 to 6 per cent return, but you have to capture some of these emerging markets to create more balance, rather than hope the 10- or 30-year Treasury will hold at these levels.