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Bond funds lose money. How bad could it get?

Bond funds lost money last month amid the uncertainty over the US Federal Reserve's stimulus policies. Has the tide finally turned? 

 
Bond funds lose money. How bad could it get?

In the past two weeks uncertainty over how quickly the US will scale back its stimulus policies has unsettled investors, creating what wealth manager Rowan Dartington calls the ‘perverse scenario’ in which both bond and equity markets have fallen.

Since 22 May when Federal Reserve chairman Ben Bernanke indicated the central bank was considering when to start reducing the huge level of quantitative easing, or money printing, it provides each month, the FTSE 100 has fallen nearly 4%.

Meanwhile, in the past month the yields on the UK’s 10-year government bonds (gilts) have jumped from below 1.65% to just over 2% as investors have dumped the stocks, causing their price to fall.

Energetic winners

Not everything has fallen though, by any means. The latest funds data shows that Guinness Alternative Energy was the best performer in the past month (3 May to 4 June), soaring 13.6%. The fund, run by Citywire A-rated Edward Guinness and Matthew Page, remains 48% down over three years, however.

Funds investing in smaller US companies also did well with Fleming Family and Partners, Legg Mason and JPM scoring gains of over 8%. The Fleming and JPM funds have also done okay over three years with gains of over 30%.

But as often in these nervous markets it is the losers who grab the most attention.

Last month's turkeys

The specialist JPM Turkey Equity fund has slumped nearly 13% in the past month as protests against prime minister Erdogan grew, undermining the confidence of investors who may have reckoned it was time to take profits on an emerging market that has soared in recent years.

Asian property funds that have benefited from the enormous liquidity that Japan has pumped into its stock market since April, tumbled at the prospect that the largesse could fail to prevent interest rates from rising. The Henderson HF Asia Pacific Property Equities fund slid over 11%, followed by First State Asian Property Securities down nearly 10%. 

Japan and gold funds have also suffered. The rush to take profits after an exhilarating nine months meant Baillie Gifford’s and Threadneedle’s Japanese smaller companies funds dropped more than 8%.

The Junior Gold and Ruffer Baker Steel Gold funds matched these falls as investors took the view that a reduction in money printing by the US Fed would further undermine the attractions of the precious metal, and the mining companies that dig it out of the ground.

Bond funds get battered 

But the real story lies further down the list of fallers.

As the Financial Times yesterday reported, bond funds have had a testing time as investors have panicked that whatever the Fed decides to do, the game may be over for bonds. The bull market in bonds, as Pimco’s Bill Gross and others have recently declared, looks to be over if the US economy is strengthening and if the extraordinary gamble of QE enters its end game.

Unsurprisingly, the higher risk end of the bond spectrum was hardest hit.

Emerging market bond funds from the likes of First State , Pimco , Investec,Legg Mason   and Barings fell between 4% and 7% last month as investors turned their attention back to the US and the strong dollar.

Closer to home, funds investing in longer maturity bonds took a similar hammering. This was entirely predictable. Bonds do badly when interest rates rise, making their fixed levels of interest unattractive. Those with longer duration – or a higher exposure to interest rate rises – do worst of all, as AXA’s Theo Zemek yesterday reminded us when she recalled how government bond funds were smashed in 1994, when interest rates rose unexpectedly.

This is why bond fund managers have been cutting duration as much as they can in order to protect investors. But even the M&G Strategic Corporate Bond fund, a popular fund managed by Richard Woolnough (pictured) which has a flexible ‘whatever it takes’ policy within it’s the asset class, lost 2% last month. The fund is a favourite of our Citywire Selection team and lies second in its sector over five years with a 77% total return.

Has the tide finally turned against bond funds?

We’ll hear what Woolnough, who received his last Citywire performance rating nine months ago, has to say tomorrow when we join a webcast with the fund manager. It will be really interesting to hear what he has to say.

But there is no doubting that investors are nervous.

Mark Burgess, chief investment officer at Threadneedle Investments, has said the group has started to ‘reduce our large overweight in investment grade credit’.

The price of the high quality corporate bonds he refers to are linked to the prices of developed market government bonds. As these government bonds have soared in response to the immense QE buying power of the Fed and the Bank of England, they have taken corporate bonds with them.

Investors such as Burgess fear a bubble has formed and that the recent sell-off is an indication of how markets might respond to the gradual withdrawal of QE and the eventual rise in interest rates.

Opinion is divided as to what the Fed will do and when it will act. Russ Koesterich, global chief investment strategist at BlackRock, believes the US economy is not so robust and that the Fed will not seek to stop QE and raise interest rates until next year at the earliest. He and everyone else will be watching the next US jobs figures on Friday with interest.  

If true, this may give bonds more time but the market does appear to be running out of road. 

'Lose, lose' for government bonds

In a report this week Swiss investment group Pictet Asset Management said investors in government bonds were in a 'lose, lose situation' over the next few years.

'Should growth accelerate at an unexpectedly sharp pace, yields will inevitably head higher from their historically low levels' [and bond prices will therefore fall]. 'Should the opposite occur and business conditions deteriorate, the likely response from policymakers – a further round of monetary stimulus – can be expected to fuel concerns about inflation' [which bonds hate].

This then raises the issue of whether investors should get out of the asset class entirely or seek pockets of safety and good value. The trouble is lower quality, high yield corporate bonds and emerging market bonds are expensive too. Higher volatility and lower returns look inevitable over the next few years.

Luca Paolini, Pictet's chief strategist, favours emerging market bonds on a five-basis, arguing the fundamentals are favourable given the relatively healthy financial state of their economies. However, their short-term prospects look cloudier if investors continue to withdraw their money at the current rate, attracted by the strong dollar, and discouraged by the threat of something nasty in China.

6 comments so far. Why not have your say?

Tony Peterson

Jun 05, 2013 at 16:45

It has been almost miraculous that bonds and bond funds had not been toasted a year or more ago. But toasted they will be. Or indeed are being.

The interest rate cycle is bottoming out at last. Interesting times.

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Keith Snell

Jun 05, 2013 at 17:25

The fall of markets however annoying to those of us who invest our hard earned income was bound to happen as we all know if the Fed and all other Sovereign banks all decide to stop printing money and manipulating the market in the process and in concert, our shares are bound to fall in value. As we can also see holding bonds [of which I have held none for quite a time] and gold which I only have a minor investment in does not seem attractive either. I suppose shorting entire markets is one possibility. All I have done to date is take profits and sit on the cash waiting for something that looks worth investing in turns up.

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masud butt

Jun 05, 2013 at 23:37

Look like we can never win for now. think long term, nobody know what will fed do.

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Maverick

Jun 07, 2013 at 16:29

If you look back at the 1950s and 60s, there were whole decades when you would have lost money holding bonds. Google the name "George Ross-Goobey" when you've got a spare five minutes.

Yields on equities are now showing the same differential from bond yields as in the 60s. I see no reason why the result should be any different now.

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Tony Peterson

Jun 07, 2013 at 16:51

Thanks, Maverick, for a helpful post.

I think you might have added that there were also whole periods when you could make serious money holding bonds (as my wife and I did with gilts between the seventies and nineties).

Interest rates run on a long cycle. When they have been artificially depressed, as of the last three or four years, the inevitable correction will be long and painful for holders of fixed interest securities. I see no sensible alternative for investors, to stakeholding in profitable enterprises. Equities. No amount of posts from sneering doomsters will convince me otherwise.

And although my gain since the new year has fallen from 23% to 17% I regard every drop as a new buying opportunity.

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Anonymous 1 needed this 'off the record'

Jun 08, 2013 at 12:11

The impact of QE withdrawal is unknown and could be massive. Not just on the bond and equity markets, but also on the real economy as the interest rates cycle will also turn higher.

How affordable will higher interest rates be for the governments and their citizens, who are all massively indebted. The main reason for the QE has been to lower the long term interest rates. Are we ready for higher long term rates?

For that reason, despite the Fed talk, I do not believe that the global printing presses will stop anytime soon. We may be in this printing environment, for a very long time.

However, if the governments are forced to stop printing (by the market), then who knows where are headed next.....I observe

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