With Gross Leaving PIMCO, Consider A True Alternative To Bonds by Merk Funds

With Bill Gross leaving PIMCO, all of us get inundated with sales pitches for a bond alternative. But if the 30 year bull market in bonds is coming to an end, are you looking at the right place?

Gross leaving PIMCO: Bonds at risk?

The concern over rising interest rates has become a primary issue with investors. While few assets are immune to rising rates the bond market may be particularly vulnerable. The headwinds may be exacerbated by changing fundamentals in the U.S. bond market, specifically; growing concentration, extended duration and changing correlations posing a greater challenge for investors to manage their duration risk. More concerning to investors may be that that, as we will show, the benefits of bonds as portfolio diversifiers may have eroded. Is the bond market at a turning point? How should one invest in a rising rate environment? Our analysis suggests that in addition to active risk management within a fixed income allocation, building a more diversified portfolio with the inclusion of alternative assets may provide investors with an improved risk-return trade-off heading into a period of rising interest rates.

The end of the 30-year bond bull market?

As the year comes to an end, 2013 has left the U.S. fixed income market scarred. In contrast with the stock market’s repeated new highs, the U.S. bond market as measured by the widely followed Barclays U.S. Aggregate Bond Index, has posted its first negative calendar year return1 since 2000; only the third negative year in the index’s 37-year history (Figure 1). Along with the lagging performance the U.S. bond market has experienced rising volatility and a shift in investor sentiment.

Bonds Bill Gross

Speculation of the Fed winding down its quantitative easing (QE) program and fear of rising short-term interest rates has dominated the bond market in 2013. More profoundly, it seems investors are increasingly moving to the consensus that the U.S. fixed income market may be approaching a key turning point: the end of a 30-year secular interest rate decline which started at the height of the Volcker-era tight-money policy and which was fueled by recent extraordinary monetary easing (Figure 2).

Bonds Bill Gross

Down the road, pervasive market expectations of higher interest rates could put continuous pressure on bond prices. Adding to the risk, current bonds yields are near historical lows and seemingly have nowhere to go but up. The total return on bonds is the combination of income and price movement. In previous periods when interest rates rose relatively high coupon payments often provided an effective buffer to the total return on bonds. Now, however, with yields near record lows, the income bonds generate may not be sufficient to offset the loss from price decline due to rising interest rates, resulting in a loss in total returns.

In addition to the rising rates expectation, adding to the bond market risk is the Fed’s lack of effective communication on policy path, uncertainty surrounding the U.S. fiscal impasse and rapidly growing U.S. long-term debt. Moreover, inflation risk may materialize sooner than the market expects but has not yet been priced in.

How “safe” is your bond portfolio?

With this backdrop investors may want to take a close, hard look at the risks associated with the fixed income component of their portfolios. Bonds are traditionally considered a “safe” haven compared to riskier stocks in their long-term asset allocation. But the term “safe” is misleading; fixed income investments are subject to interest rate risk, credit risk, liquidity risk and prepayment risk among others. Given the current market circumstances investors may agree that interest rate risk poses the primary threat to most fixed income portfolios. What is less acknowledged are some specific changes to underlying fundamentals in the U.S. fixed income market.

See full Gross leaving PIMCO: Bonds at risk? in PDF format here.