Q2 in Review – A Tale of the Bipolar Bond Market

bondsDictionary.com defines “bipolar” as “characterized by opposite extremes.” In searching for a word to describe the bond market’s behavior during the second quarter of 2013, bipolar seems rather appropriate.

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In terms of yields, the 30-year U.S. Treasury dropped 29.4 basis points from the start of Q2 through May 1 before reversing in a major way and climbing more than 80 basis points from the quarterly low. The 10-year Treasury exhibited similar behavior, falling 23.8 basis points to start the quarter and then rocketing higher by more than 100 basis points from its May 1 low to its June 24 quarterly high. Even the 5-year Treasury had an explosive rally (in yield) off its quarterly low, climbing more than 90 basis points in May and June after falling 12.8 basis points during the beginning of the quarter.

Treasury yields weren’t the only thing looking rather bipolar during the second quarter. ETF Fund flows started the quarter extremely strong before reversing in a big way beginning in mid-May. With the final week of the quarter still to be reported, the first 12 weeks of Q2 were a perfect split of six inflows and six outflows. And although the quarter ended extremely weak, it should be noted that on the whole, there were actually Q2 net inflows for both U.S. and international fixed income.

etf fund flows

On the mutual fund side, the Investment Company Institute reported $30.437 billion of inflows during April and May only to be followed by $32.350 billion of outflows in June (final week still to be reported). June 2013 looks like it will be the worst month for bond mutual fund outflows since October 2008’s $41.277 billion and only the fifth time in four-and-a-half years that there has been monthly outflows from bond mutual funds. Moreover, June’s outflows breaks the streak of 21 consecutive months of bond mutual fund inflows.

In addition to the huge swings in yields and fund flows, corporate bond spreads, specifically high yield bond spreads, also joined the party. For a breakdown of the BofA Merrill Lynch Q1 2013 closing spreads, the Q2 2013 high and low spreads, and the Q2 2013 closing spreads by ratings category, see the table below (spreads in basis points):

closing spreads

As you can see, the high yield part of the corporate bond market saw notable spread widening from the May lows to the June highs. But even the highs reached during June are nowhere near where one would expect them to go in a mild recessionary environment. The 907 basis points spread to Treasuries in the CCC-or-below-rated part of the corporate bond market is about the minimum I would expect to see for the entire high yield corporate bond market during a recession. So despite the strong move wider in high yield bond spreads, if a recession were on the horizon, there would still be a ways to go.

What did, however, reach extreme levels during the June selloff in bonds was the number of advancers to decliners in corporate bonds and the incredible discount to net asset value in one particular municipal bond ETF. In terms of corporate bonds, the number of advancing issues to declining issues reached levels that were about as bad as I would ever expect to see. To illustrate just how bad things got, I created the following table showing the quotient from dividing the number of advancers by the number of decliners during each trading day in the last two weeks of June (underlying data from FINRA’s Trade Reporting and Compliance Engine).

june numbersDuring the last two weeks of June, the number of advancers to decliners in the corporate bond market reached the extremely depressed level of 0.207 before quickly rebounding to the other extreme at more than 2. What caused the advancers to decliners to reach such extremely low levels on June 20 and June 24? It was the atypical combination of a large jump in benchmark Treasury yields on the same day that the corporate bond market also experienced a large jump in spreads. In a more typical environment, corporate bond spreads widen in a declining benchmark yield environment and contract in a rising benchmark yield environment. Therefore, if spreads are widening, falling benchmark Treasury yields can offset the downward pressure to corporate bond prices, especially in the investment grade market. That didn’t happen this time around.  Instead, the perfect storm of widening spreads and rising benchmark yields caused most corporate bonds to fall in price.

Finally, the stresses in the municipal bond market could not only be seen in the beating various muni bond funds took, but also in the extreme discount to net asset value of one particular ETF, the Market Vectors High-Yield Municipal Index ETF, ticker symbol HYD. In the June 24 article, “HYD: A Rare Opportunity In This Municipal Bond ETF,” I pointed out the extreme discount to net asset value at which HYD was trading. That day, the discount actually widened to more than 9% on an intraday basis before rapidly changing directions and closing at a premium of 0.26% just two trading days later. The massive discount to net asset value and the rapid disappearance of that discount proved to be a good example of why it pays to be “greedy when others are fearful.”

In recent days, we’ve started to hear pundits claim that once retail investors get their monthly/quarterly statements over the coming days and see the damage to the bond portion of their portfolios, more bond market selling will commence. If that actually happens, get ready to back up the truck and buy all you can. We still live in a largely disinflationary environment with structurally deflationary undertones. If retail investors want to push intermediate- to long-term corporate bonds further into real yield territory, it will absolutely be a buying opportunity for true long-term bond investors.

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