The exodus of bond funds creates good business

0

Text size

Good deals abound in bank bonds? Maybe, said Bank of America in a recent study.

dream time

Investors are massively fleeing corporate bond funds. This means that bonds in some sectors, including banks, look cheap.

Withdrawals from investment-grade corporate bond funds totaled $28 billion, net, over the past 21 weeks, according to Refinitiv Lipper. This represents approximately 1.6% of the total assets invested in the market before the start of the sale.

Behind the exodus of investors: the Federal Reserve and its measures to rapidly raise interest rates to combat soaring inflation. Due to their long maturities and low coupon payments, higher quality corporate bonds tend to perform poorly during periods of rising interest rates. The Treasury market has lost 5.6% this year, according to the ICE indices, and well-rated corporate bonds have fared less well, posting a loss of 7.7%.

“I can’t tell you how many people we work with tell us how awful the bond market is,” said Gibson Smith, founder of Smith Capital Investors. “Now you have amplified hate in that the bond market has produced very negative returns in a very short time.”

Investors are also seeing increased risk in the corporate bond market, with investment grade corporate yields climbing faster than Treasury yields this year. Spreads between corporate bonds and Treasuries reached their widest point since late 2018, when investors worried about an aggressive pace of Fed tightening and the potential burden on businesses.

While corporate debt underperformance often reflects default fears (US Treasuries generally have no default risk), fund managers and strategists are more concerned about liquidity risks. When investors quickly exit bond funds, managers tend to sell more liquid bonds because they can offload them the most easily. This can lead to underperformance in the most liquid segments of the market.

Take into account


iShares iBoxx $ Investment Grade Corporate Bond ETF

(ticker: LQD) lost 13% this year, as the fund lagged the ICE 5+ Year US Corporate Index, which has a longer duration and lost only 10%. This suggests that the most traded bonds – those that are traded enough to be used in ETF baskets – are selling.

Selling pressure can also create windfalls in certain corners for investors who don’t mind buying bonds outright to hold them to maturity.

Bank bonds, for example, are the largest constituent of the LQD ETF, accounting for around 25% of holdings. The big banks announced mixed results for the last quarter. But their bonds are trading cheaper than expected given their low risk of default, according to a recent study by


Bank of America
.

In other words, bank bonds are cheap.

And at some point, high-quality bonds will offer yields high enough to attract investors. The market is likely very close to assessing the full path of future Fed rate hikes, Smith says, so the worst may soon be over for high-quality bonds. He bases his view on the fact that corporate bonds now offer positive yields relative to future bond market inflation expectations.

“If yields were to rise 20 to 25 basis points, that would make it even more attractive,” he said. “We may be a little ahead in that regard…but we’re getting there.”

Of course, this assumes inflation falls as much as bond markets expect. If not, bond investing might not become much more popular.

“If inflation does not come down, all financial markets – all capital markets – would be preparing for a significant correction,” he said. “It’s stocks, credit and bonds in general.”

Write to Alexandra Scaggs at [email protected]

Share.

Comments are closed.