Fed bond bubble: Still look like scariest market to you?

They may not be paying much, but bonds are suddenly looking pretty good.

Last week, while stocks plunged, government bond prices rose sharply. The yield on the 10-year Treasury fell more than 15 basis points to 2.05 percent in the last two days of the week. On Monday morning, the 10-year yield dipped below 2 percent.

Remember those fears of a Fed rate hike bond bubble and the 10-year going to 3 percent?

With the stock market in a free-fall, fixed-income investors anxious about coming interest rate hikes by the Federal Reserve might feel a little better about boring bonds and their measly coupons.

Carl Court I Getty Images An employee views trading screens at the offices of Panmure Gordon and Co. in London.

Carl Court I Getty Images
An employee views trading screens at the offices of Panmure Gordon and Co. in London.

The end of the decades long bull market in bonds has been anticipated for years, but that doesn’t mean the bond market is headed for a precipitous decline. Investors who have nearly $4 trillion invested in fixed income mutual funds and exchange-traded funds should not head for the exits, especially comparing the U.S. bond outlook to the current stock market correction, with the Dow down by more than 1,000 points at one point on Monday morning.

“What commodity will crash next? What currency will collapse? It’s hard to imagine rates rising rapidly from here,” said Elaine Stokes, co-portfolio manager for the $22 billion Loomis Sayles Bond Fund.

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Investors may not see big gains in their bond funds but they probably won’t see big losses either.

“Part of the role of bond funds is to diversify against equity risk. They can offset losses in stocks,” said Matt Tucker, head of the iShares fixed-income strategy team at BlackRock.

Factoring the fallout from a Fed move

Even if the Fed makes good on its plan to raise short-term interest rates, fund managers expect them to move slowly and expect rates to remain low for a lot longer.

“There’s no consensus that the Fed should raise [short-term] rates. Maybe they raise them this year…maybe next year. Maybe they don’t raise them at all,” Stokes said

“If investors have a long-term, strategic allocation to fixed income, the Fed’s activity shouldn’t change that,” Tucker said.

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Right now it looks like good advice for investors not to fight the Fed, especially considering the rate at which bonds should decline versus a day on which the Dow experienced a record decline.

The rule of thumb for fixed-income declines is that the price of a bond will drop by 1 percent per year of duration for every 1 percent rise in prevailing interest rates. A 10-year bond would theoretically drop by 10 percent if rates go up 1 percent. An intermediate bond fund—the most popular fixed-income investment for U.S. investors—would fall by 5 percent if it has an average duration of 5 years.

Prior to last week, investors appeared to be preparing for a September rate hike and a rise in long-term rates. BlackRock’s Tucker said some of the company’s most conservative, shortest duration funds like the iShares Floating Rate bond ETF (FLOT) and the iShares 1-3 year Treasury bond ETF (SHY) have had big inflows in the last several weeks. The funds currently yield just 50 basis points and 53 basis points respectively.

“What commodity will crash next? What currency will collapse? It’s hard to imagine rates rising rapidly from here.”-Elaine Stokes, co-portfolio manager for the $22 billion Loomis Sayles Bond Fund

Bond fund flows

For the one-week period ended last Thursday, U.S. bond funds were the big winner among ETFs, with four of the top five ETFs for new investor money coming from the U.S. fixed income asset class, according to ETF.com data. The No. 1 ETF for inflows was the iShares 20+ Year Treasury Bond ETF (TLT) which saw $511 million in investor flows during the week. That was followed by the iShares iBoxx Investment Grade Corporate Bond ETF (LQD), which had $428 million in flows, and the iShares 1-3 Year Treasury Bond ETF, at just under $400 million in net flows for the week. That was followed by the PIMCO Enhanced Short Maturity Strategy (MINT), which pulled in $375 million.

Last week, those five bond ETFs took in a combined $1.7 billion. By comparison, just a week earlier there was only one bond ETF in the top 10 for weekly flows, the iShares 7-10 Year Treasury Bond, with $181 in new money.

Top 5 intermediate term bond ETFs

1. iShares 7-10 Year Treasury Bond
Assets: $7.2 billion
Expense ratio: 0.15 percent
1-month return though 8/20: 2.4 percent

2. iShares Intermediate Credit Bond
Assets: $6.3 billion
Expense ratio: 0.20 percent
1-month return though 8/20: 0.30 percent

3. Vanguard Intermediate Term Bond
Assets: $6.2 billion
Expense ratio: 0.10 percent
1-month return though 8/20: 1.3 percent

4. iShares 3-7 Year Treasury Bond
Assets: $5.5 billion
Expense ratio: 0.15 percent
1-month return though 8/20: 1.1 percent

5. Vanguard Intermediate Term Corporate Bond
Assets: $5.4 billion
Expense ratio: 0.12 percent
1-month return though 8/20: 0/43 percent

(Source ETF.com, data through 8/20)

Tucker recommends that investors not shift out of their higher-yielding intermediate-term bond funds solely out of fear of the Fed. “This cycle of rate-raising is going to be longer and slower than many in the past,” he said.

John Collins, director of investment advisory at Aspiriant, which manages $8 billion for clients, also thinks investors don’t need to worry much about the Fed and need to remain exposed to intermediate term bonds.

Collins has adopted a more defensive position in the last 18 months, reducing duration and credit risk by scaling back overweight positions in high-yield and municipal bonds, but he’s sticking with allocations to intermediate term funds. “We’re focused on quality managers in the intermediate portion of the market,” Collins said. “I’m not saying there’s no risk, but properly positioned, we think fixed income provides ballast and diversification for our clients.”

Blackrock thinks that with low inflation and low expectations for growth, long-term interest rates won’t necessarily rise in step with Fed rate hikes. “We advise investors to stay the course and not worry about drastic increases in interest rates,” Tucker said.

The central bank has given ample notice that it plans to raise short term interest rates for the first time since the financial crisis. With short-term rates at zero for more than six years, however, no-one knows how the market will react to a rate hike, which has led to some investor hysteria.

“We keep having things that are expected treated as unexpected when they happen,” Stokes said.

But right now, bonds aren’t the part of the market taking many investors by surprise. They might need the ballast offered by bonds for a while.

By Andrew Osterland, Special to CNBC.com

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