Despite the stock market rally over the past three years, investors have pulled billions of dollars from equity mutual funds. And where has most of that money gone? Bond funds. Corporate, municipal and mortgage funds have benefited from the equity fund outflow. Most have had spectacular runs over the past three years. But it might be time to take profits.
With the looming fiscal cliff, it seems bond investors are sniffing out the possibility of lower corporate profits, lower personal income, further damage in the commercial real estate market and more weakness in the housing market. Even if we can avoid plunging off the cliff, higher taxes and lower government expenditures seem inevitable. And that will ripple through the bond markets.
Higher taxes means less personal income, putting housing further out of reach for many. Less discretionary income means less consumption so businesses will see lower profits. Lower profits eventually lead to lower rents and do not bode well for the commercial real estate market. And lower profits will drive corporate borrowing costs higher.
But what about QE3 you ask? Shouldn’t the Federal Reserve’s policy of buying Mortgage backed securities keep a floor under the bond market? Maybe, but every previous iteration of quantitative easing has produced less and less bang for the buck. The market may be waking up to the fact that the Fed’s asset buying program is at the point where it fails to move the needle.
And as the end of the year approaches, many bond investors look to be locking in profits gained during the recent bull market. The only corner of the bond world holding up is the municipal sector but I believe it too will soon join in the decline. A couple of examples;
- The iShares High Yield Corporate Bond Fund holds mostly corporate bonds rated in the B to BB range. The lower the rating, the higher the yield. Conversely, lower rated bonds will be the first to fall in value as corporate profits decline. From a technical standpoint, HYG has broken down decisively through the 200 day moving average.
- The iShares MBS Fixed Rate Bond Fund holds mostly Aaa rated Fannie Mae bonds. It is my belief that the government will get more aggressive about principal reductions and mortgage relief over the next year. If so, the value of Fannie (and Freddie) bonds will take a pretty substantial hit. The share price of MBB will suffer as a result. Technically, MBB has broken below the 50 day moving average
- The Market Vectors High Yield Municipal Index holds mostly non-investment grade municipal bonds is so far holding its own. But as more and more municipalities have trouble raising revenue and as defaults become more widespread, investors might find the valuation of this ETF a bit rich.
- One last thought. With the "Fiscal Cliff" looming, the solutions that Congress and the White House will agree to probably won't be enough to stave off another downgrade of The United States credit rating. Interest rates will have nowhere to go but up. The iShares Barclays 20+ Year Treasury Bond Fund holds only long term treasury debt. As interest rates rise and bond prices fall, the share price of TLT will follow. From a technical perspective, 10 and 30 year U.S. Treasurys seem to be tracing out a series of lower highs and lower lows. Not something welcomed by bond bulls.
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