For U.S. bond funds, the long and short of it have been the whole story this year. Quite literally, money has flowed into the two extreme — short duration or long-term bonds — and steered clear of the middle, the latest data from Thomson Reuters Lipper shows.
During the first quarter, investors have pulled funds from bonds with maturities of three-to-10 years. If investors shun the category, the so-called intermediate-range bonds should begin to command higher yields to restore their fan base.
But some factors are working against the intermediate-sector that might limit their appeal.
To start with, it reflects an investment world that sees in a binary way: The mindset is that the economy is seen either too hot or too cold. The inflation bears are staying on the short end and slow-growth prophets are holding to the long.
In normal times, investors who are not swayed to either end might like intermediate maturities. But in an extended era of super-easy monetary policy, the historical patterns are shifting.
"There's no middle ground. People are either in or out," said John Lekas, president, chief executive officer and senior portfolio manager at Portland, Oregon-based Leader Capital Corp.
In portfolio 101 terms the bond market has formed a classic "barbell" shape: A thin pole in the middle, and a lot of weight piled up at the two ends. The highly diversified "pyramid" or laddered style of investing has lost followers.
Lekas's short-term bond fund was the top performer in the sector for the first quarter with returns of 2.51 percent, according to Lipper. But his firm likes the long bonds' prospects as well. Leader Capital Corp.'s total return fund, launched in August of last year, has added a 4 percent allocation to 30-year U.S. Treasury bonds in the last two weeks. It was up 5.07 percent in the first quarter.
That contrasts against the world's largest bond fund manager, Pimco, which in February sold all of its U.S. Treasury holdings from its Total Return fund, the single biggest bond fund.
The Great Debate: Inflation of Deflation
Pimco went far out on a limb to dump U.S. Treasurys at a time when most dealers and big investors stayed in.
"Pimco is just wrong, it is as simple as that," said Lekas.
Bill Gross, Pimco's co-chief investment officer, has questioned who will buy Treasurys once the Fed stops its latest round of bond purchases in June.
Lekas said he believes the Fed is interested in a 'low dollar' policy to force commodity prices higher. Under this scenario commodity-based equities would continue to rise until costs for the rest of the economy become too burdensome, resulting in lower GDP.
"The 30-year represents GDP, so if you think GDP is going lower you buy the 30-year. Simple."
Not everyone agrees with Lekas.
"We believe the curve will steepen. We are a little bit short duration overall, but that is not our core strategy. Our cores is to be overweight MBS, CMBS and particularly high-yield bonds," said Wesley Sparks, head of U.S. fixed income at Schroders Investment Management in New York.
"We don't like the long-end because that is where inflation expectations are reflected," he added.
Redemptions in the Middle
In the latest quarterly data, Lipper shows that out of a universe of 201 intermediate-term bond funds, net outflows totaled $3 billion.
Long-term bond funds had inflows of $31.7 billion, on pace for its best year in the last four. Short-term bond funds have also had inflows, albeit a more modest $3.5 billion, well off the pace of the last two years.
In April, the latest weekly flow data shows the same pattern continues with cash moving out of intermediate into long and short-term funds.
Buying the long-end gives more yield. The short-end gives protection from rising rates but also higher liquidity, thereby offering a greater level of safety with more yield than a plain vanilla money market fund.
"It seems to be this polar activity that is tearing apart the intermediate sector. We are three months into the year and therefore we have a pretty good trend in hand. I would figure this should be a very good year for flows into the long-term bond funds group," said Jeff Tjornehoj, senior research analyst at Lipper.
How to Play It
Intermediate-term bond funds, according the benchmark Barclays Aggregate index, have underperformed the long-term segment of the market year-to-date, with total returns of 1.64 percent versus 2.01 percent.
"Advisers are trying to find more specific strategies for their clients than their catch-all intermediate investment grade category," Tjornehoj said, citing one of the main reasons for this split in the market.
Among the long-term fund choices that advisors could consider are high-yield, bank loan funds or global income funds.
Bank loan funds — funds that invest primarily in floating rate notes rated below investment grade — have had steady net inflows for the past 42 straight weeks.
"Mathematically, yes, they are short-term, but from a risk profile, it resembles a long-term fund because they are more volatile than short-term funds," Tjornehoj said.
The best performing bank loan fund tracked by Lipper's weekly flow data is the Eaton Vance Floating-Rate Advantage Fund, up 3.36 percent in the first quarter.
In the first quarter, bank loan funds had net inflows of $15 billion, global income funds took in a net $7.5 billion and high yield had inflows of $3.4 billion.
For Tjornehoj, this represents investors willing to hunt for yield, step out of the benchmark comfort zone and take on more risk.
The environment that was so attractive to intermediate bond holders — enough added yield without taking on long-term risk — is diminished by the interest rate versus growth dynamic. The sector might suddenly regain its allure at some point.
But even one intermediate-term bond manager whose funds have not experienced net outflows says there is higher vulnerability for the sector.
"(The Fed is) committed to continuing their quantitative program, QE2, but they have not committed to QE3, so that has the potential to hurt the intermediate part of the curve maybe a little more than the longer-part," said Matt Freund, lead portfolio manager of the USAA Intermediate Term Bond fund, based in San Antonio, Texas.
"We are generally barbelled and slightly short-duration relative to the index and relative to our peers," he said.
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