Fixed income investors have recently expressed fears that U.S. interest rate increases are closer than originally expected after Fed Chairman Bernanke’s comments at a Congressional hearing that led to a dramatic sell-off in the bond market.
The 10-year Treasury yield entered the month of May with a yield of 1.64% and reached 2.21% by June 10th. Interest rate volatility has also increased since the May 22nd hearing.
Through May, taxable bonds had experienced over $110 billion in net inflows, according to Morningstar. Only recently, however, have flows into fixed income mutual funds turned negative. On June 19th, Lipper reported $17.7B in outflows to date in the month. Investors that were demanding greater yields are now showing signs of nervousness. The question facing these investors is where best to allocate the funds sourced from a bond portfolio. More importantly perhaps, in an environment where investors have sought anything providing yield, which assets are best suited to replace the lost income stream without incurring additional portfolio volatility?
The recent marketplace has clearly been a Pandora’s Box for income-seeking investors. Investors fearful of rising rates and looking to sell fixed income holdings may choose to allocate to equities, invest in alternatives or hold cash. Each carries its own set of risks as described below.
Although inflation fears have subsided, the choice of allocating to cash is effectively guaranteeing a negative real rate of return (nominal return less inflation). Though many cautious institutional managers have chosen this route, many retail investors are dependent on income and locking in a zero yield is not an option. Some investors will choose to stomach the price volatility of their bond portfolios to maintain a stable level of income and refuse to rotate into equities or cash. Others may consider a third choice by adding alternative exposure to their portfolios.
Market returns would tell you that the default answer for flows has been equities, as the S&P 500 Index has increased more than 3% since the beginning of May. That performance has not been without a significant increase in volatility, however. The most common measure of volatility, the VIX, has increased 27% over the same time period. (May 1-June 14)