Q1 Bond Market Review – The “Great Rotation” That Never Was

bond market updateThe first quarter of 2013 is now over, and, surprise, the bond market still hasn’t collapsed.  Yes, there was a minor rise in intermediate- and long-term Treasury yields.  The 10-year Treasury rose about 10 basis points in yield and the 30-year Treasury yield rose around 15 basis points.  At the high point of the quarter, the 10-year Treasury yield had risen about 33 basis points before falling during the second half of March.  The 30-year Treasury yield also rose about 33 basis points from its 2012 year-end close to its Q1 2013 high yield.

Perhaps most surprising about the move higher in Treasury yields is that it was so weak.  With broad-market equity indices hitting new nominal all-time highs and all the talk of a “Great Rotation,” one might have imagined a far greater rise in intermediate- to long-term Treasury yields.  But for the long-term-oriented fixed-income investor, those moves in benchmark yields are barely worth mentioning.  Add to this the spread contraction in corporate bond yields, and investors who favor that part of the bond market might have been surprised by the lack of volatility in their corporate bond portfolios during the quarter.

From its January 2 high of $121.31 to its March 8 low of $118.65, the iShares Investment Grade Corporate Bond ETF, LQD, fell just 2.19%.  For the quarter, LQD, ex-distributions, fell just 0.90%.  Given the volatility financial markets have experienced over the past five years, those types of moves, even for a broad-based bond market ETF, are pretty uneventful.  Even the iShares High Yield Corporate Bond ETF, HYG, saw relatively muted moves.  For the quarter, it was up 1.07%, ex-distributions.  And its January 25 quarterly peak of $94.97 to February 7 quarterly low of $92.81 was only a 2.27% move—again, rather uneventful.


Corporate Bond Market Spreads

In terms of corporate bond spreads, the “BofA Merrill Lynch US Corporate Master Option-Adjusted Spread” dropped three basis points on the quarter, from 154 on December 31, 2012 to 151.  The spread got as low as 144 basis points on three occasions: January 28, January 29, and March 14.

The “BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread,” representing the high yield corporate bond market, declined from its 2012 year-end spread of 534 basis points to a Q1 2013 quarter-end spread of 486 basis points.  Its low point of the quarter was on March 14 at 471 basis points.

For a breakdown of the BofA Merrill Lynch 2012 and Q1 2013 closing spreads by ratings category, see the table below (spreads in basis points):

Rating2012 CloseQ1 2013 Close

Not surprisingly, given the general risk-on nature of financial markets in Q1 2013, the junkiest of junk bonds (CCC-rated or below) saw the largest spread contraction during the quarter, followed by B-rated, and then BB-rated bonds.  Bonds in the highest reaches of investment grade saw spreads barely budge, declining by just one basis point on the quarter (AAA-, AA-, and A-rated bonds).


The “Great Rotation” That Never Was

During the first quarter of 2013, talk of a “Great Rotation” out of bonds and into stocks reached fever pitch.  Reading that nonsense on nearly a daily basis left me feeling as if it was simply the latest attempt by an equity-enamored financial media to scare everyday investors out of bonds and into the stock market.  Did it work?  Let’s take a look.

When examining bond market fund flows, two places investors should focus their efforts are on mutual funds and ETFs.  For mutual fund data, we can turn to the Investment Company Institute (ICI), which provides weekly fund flows for taxable and municipal bond funds.  Regarding ETF fund flows, IndexUniverse.com is a great resource.

According to ICI, which covers 95% of mutual fund assets, fund flows into bonds during the first quarter of 2013 totaled $66.914 billion.  While this trailed last year’s $92.095 billion of inflows during Q1, $66 billion is still quite a solid amount of inflows and certainly nowhere near the mass exodus out of bonds that the “Great Rotationists” were predicting.  Additionally, you might be interested to know that Q1 2013’s inflows into bond mutual funds eclipsed the Q1 2011 inflows by $45.507 billion.  Even when stripping out the negative flows from the municipal bond selling that occurred in Q1 2011, taxable bonds only garnered $40.755 billion.  In 2013, taxable bonds took in more than that in January and February alone.

For a monthly breakdown of ICI’s Q1 2013 fund flows data through March 20, 2013, see the table below (data is still subject to change):

2013Total BondTaxable BondMunicipal Bond
January$32.743 billion$25.599 billion$7.143 billion
February$20.165 billion$17.710 billion$2.455 billion
March$14.006 billion$14.260 billionneg. $252 million
*March data through 3/20/13

In the world of fixed-income ETFs, inflows were again the name of the game.  According to IndexUniverse, January 2013 had inflows of $752.85 million and $1.06155 billion into U.S. fixed income and international fixed income respectively.  In February, ETF inflows totaled $956.84 million for U.S. fixed income and $650.50 million for international fixed income.  At the time this article was written, IndexUniverse had yet to publish the final monthly ETF data for March.  But when scouring the weekly data for the first three weeks of the month (through March 22), one discovers U.S. fixed income inflows of a whopping $4.76279 billion.  That’s far more than January and February combined.  During the first three weeks of March, international fixed income saw outflows of $3.07 million.

Judging by the Q1 fund flows into bonds, the relatively muted moves higher in intermediate- to long-term Treasury yields, and the spread contraction in the corporate bond market, the imminent “Great Rotation” ended up being just another talking point for equity-focused, long-only advisors attempting to convince their clients to abandon fixed income in favor of stocks.

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