There has been so much talk that investors would respond to ultra-low interest rates in the bond market by shifting their assets into stocks that market professionals have begun to talk about it as if it were a reality; as if that kind of portfolio rebalancing is what had produced the big gains in major stock market indexes in the first quarter.
In fact, nothing could be further from the truth. There is a rotation of sorts underway, but it’s not a widespread portfolio rebalancing between stocks and bonds. Indeed, investors have demonstrated a remarkable willingness to continue investing in bonds, even as they choose to allocate more capital to stocks. Indeed, there have been times when inflows into bond funds have dwarfed new allocations to stocks, as happened in the five business-day period ended March 27. That week saw equity fund inflows account for only $740 million in total fund inflows, with taxable bond funds adding another $3.8 billion, according to data from Lipper. In other words, for every $1 of new assets that went into stock funds that week, more than $5 flowed into bond funds. Just because stocks are going up doesn’t mean every investor is willing send every last dollar after them in hot pursuit.
What is underway, however, is a rotation of a different sort. It may not be a “great” rotation, but it’s a notable one, and it shows up across all asset classes. In the world of low rates and ho-hum economic growth, it could be labeled a “risk rotation”: the willingness of investors to dial up the level of risk in their portfolios. In the first quarter of 2013, new issues of high yield bonds continued to climb, hitting $148.6 billion, according to Dealogic – about 25 percent above year-earlier levels.
Unsurprisingly, Lipper has consistently reported big inflows into high-yield bond funds. A side note: Perhaps it’s time, given what has happened to yields overall, to return to calling these securities “junk bonds,” reflecting their credit quality. They may pay higher interest in order to compensate investors for the risks of buying debt from companies with credit ratings below investment grade, but “high yield” bonds today are hardly living up to their moniker, with coupons in the single digits.
Investors in fixed income have flocked to the riskier end of the spectrum, putting money to work not only at the high end of the junk bond market, but being willing to invest in triple-C credits and even in bonds that don’t have a credit rating. Sometimes, these may be brought by issuers who don’t want the blot of having an “official” junk bond status ascribed to their bonds; sometimes, the bond issue is on such shaky footing that the issuers realize that getting an official rating from the likes of Moody’s or Standard & Poor’s would put the kiss of death on their ability to raise funds. In any event, as veteran bond investor Steve Romick of FPA noted last fall, as new bond issuance has exploded in response to the low financing costs and the hunger for yield-bearing securities, the absolute and relative amount of new issuance also has soared in the last few years, and particularly in 2012.
A similar trend toward risk explains the leadership in the stock market, where the big gains in the S&P 500 index in the first quarter were helped by outsize performances by the likes of Hewlett Packard, Best Buy and Netflix: companies whose business models still struggle along under a cloud. Still, investors, insistent on finding something that has the potential to generate more than a modest single-digit return, finally reached a point of psychological readiness to own value-priced stocks that just might turn out to be value traps.
The risk rotation has showed up in the kinds of sectors and in the regional asset allocation decisions that investors are making. EPFR Global, a division of Informa PLC, notes that flows have been notably heavy into funds that specialize in healthcare and biotechnology, as well as consumer goods -- a venture not without risk in light of the unease surrounding the financial wellbeing of consumers. The company also has noted heavy fund flows into Mexican and Japanese equity funds, as well as Chinese bond funds, with investors shrugging off concerns about whether this Japanese market rally will prove to be one that lasts or questions about the health of the Chinese economy. The risk rotation also is a factor in the sharp decline in gold. After all, it’s a safe haven and not the kind of asset that investors cling to if they are chasing yield or return.
Clearly, as Guy LeBas, chief fixed income strategist at Janney Montgomery Scott, pointed out in a recent report, talk of a “Great Rotation” out of bonds and into stocks may have an appealing logic to it, but little evidence in support of it. Don’t expect this rotation to happen any time soon, he also argues. Some kinds of investors are required to maintain a certain percentage of their holdings in fixed income, insurance companies chief among them. LeBas calculates that 45 percent of the domestic bond markets are held by these “inflexible” investors; while it’s not possible to accurately gauge how many international investors are similarly inflexible as a matter of policy or practice, it’s safe to assume that foreign central banks and pension funds aren’t likely to embark on any large-scale strategic asset re-allocations of this kind. Moreover, market jitters aren’t far enough below the surface to warrant many investors making such a call: just look at the way bond prices, including the ultra-pricey Treasury securities, respond to disappointing economic data or news reports from geopolitical hotspots like the Korean peninsula.
It’s clear that the ultra-low interest rate environment is increasingly irrational, but equally clear that while investors are trying to compensate for this by dialing up the risk levels in their portfolio, they are far from willing to simply abandon the relative safety of bonds, at least until there is a clear sign that the value of those bonds is no longer certain. In other words, any real Great Rotation isn’t likely to begin until the Federal Reserve and other central banks send an unambiguous signal that they will no longer keep interest rates artificially low. Any increase in rates would put a big dent in the value of bonds that investors hold, giving them an incentive to sprint to the exits and sell anything that they don’t intend to hold to maturity – to the extent, that is, that they have investment mandates that permit them to sell.
As for those of us who are retail investors – who have more flexibility but are less likely to have any kind of information edge when such a shift in policy becomes apparent – it might be time to think about a modest portfolio rebalancing, if not a Great Rotation. Would you still want to own the bonds or bond funds in your portfolio if interest rates climbed by one percentage point? By two percentage points? How much are you willing to pay for one dollar of relatively secure earnings in the form of a bond’s yield, versus how much are you willing to pay for the same dollar of less secure profits and/or dividends from an equity investment? Those are questions to ponder today – and, if necessary, to act on before a Great Rotation stops being something that people jabber about and becomes a reality.
