The Fed is expected to increase rates in 2015 and that might result in both increased volatility in the bond markets, along with plenty of uncertainty. Managers of bond funds who are preparing for these changes now prefer to hold cash. Interestingly, it is also a trend that’s been in place since the financial crisis.
Fund tracker Morningstar says that the top 10 bond funds in the US hold about 6.6% of their investment portfolios in cash. The growing interest in cash reserves is a clear indication that investors in the bond market are worried about declining liquidity and the difficulty in buying or selling securities quickly. Giant bond funds have attracted trillions of dollars since the recession. This reflects investors’ yearning for fixed income amidst low interest rates and irregular economic growth.
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When commodity and stock prices crashed in 2008, they had a negative impact on many investors’ portfolios. Since then bonds have been regarded as safer than other asset classes. However, the sharp increase in bond prices has sparked fears that bonds may fall back to earth, especially since the Fed has halted its bond-buying program. This will also hurt the performance of those bonds that attracted massive investment.
Bond prices have been rising this year, as the yield on the ten-year US Treasury note dropped to 2.169%. It was 3% in 2013.
Now that the economy is showing signs of growth, however, the Fed is planning to increase short term rates. Higher rates are likely to cause a drop in the price of existing bonds. That said, it still isn’t clear whether the Fed will increase interest rates next year or sometime later. Fed officials say that they are discussing when they should start increasing the rates. Many analysts believe that the rates will be revised in the middle of 2015.
Increasing bond market volatility is another thing that causes concerns. Investors are worried that they will not be able to sell their bonds at desired prices if the market trends reverse. Some observers are also worried that a collapse in the bond-market may also cause ripples in other markets and cause stock prices to crash.
Strengthen the Funds
Cash flow may hurt the performance of funds, as investors pull out, but it is one of the many strategies bond managers use to strengthen their funds against potential changes in investor sentiment. Better to be in cash than watch others pull out of bond funds and take a performance hit.
Another strategy is to turn their attention to derivatives. These are financial contracts whose value depends upon the performance of the underlying index, asset, or interest rate.
Rising Fed rates are likely to amplify trends which have made bond trading already difficult. The Barclays U.S. Aggregate bond fund index lost 2 percent last year. This is the biggest decline it registered since 1994. This year US taxable bond funds attracted strong inflows because yields had fallen. But last year, inflows into bond funds were the smallest.
Managers who have more cash may lag behind their rivals who are fully invested and as a result they may lose clients. Chances of falling behind the market are especially high when the economic growth is uneven and interest rates are low. This may result in unhappy customers and paltry returns.
Managers are going to have walk a thin line amidst all these crosscurrents as interest rates begin to de-stabilize. For investors, don’t have a panic attack if your bond fund is suddenly underperforming. Check the fund’s cash position. If it’s been rising, you may want to thank your manager for taking a short-term hit while positioning you for the future.
About Lawrence Meyers – Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at email@example.com.