Exit Anxiety Seen as Mutual Funds Hog Corporates: Credit Markets

Apr 09, 2014 3:05 pm ET

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April 9 (Bloomberg) -- The biggest buyers of U.S. corporate bonds since the financial crisis may be the least likely to stick around when the Federal Reserve raises interest rates.

Mutual funds have purchased about half of the company bonds that have been added to the U.S. market since 2008, equivalent to about $1.5 trillion of assets, according to Morgan Stanley, the fifth-biggest underwriter of the debt globally last year. That’s helped expand their share of the debt to 16 percent from 13 percent five years ago and contrasts with a decline for buyers such as pension funds and life insurers that tend to hold onto the securities longer.

The shifting base is increasing the risk that five straight years of gains will end for a section of the market that’s been among the biggest beneficiaries of both mutual-fund demand and the Fed’s easy-money policies: shorter-term notes due in one to five years. Returns on that debt last quarter trailed gains on longer-term securities by the most since the three months ended September 2011, Bank of America Merrill Lynch index data show.

“A lot of the mutual fund ownership has been in the front- end, so if we have a significant rise in rates in that part of the market, at some point investors may look to other opportunities,” said Sivan Mahadevan, a credit strategist at Morgan Stanley in New York. “That’s one of the catalysts that we’re watching.”

Unprecedented Cash

Investors began pouring unprecedented amounts of cash into mutual funds that buy bonds after markets recovered from the credit seizure six years ago, fueling a 72 percent return in debt sold by the most-creditworthy to the riskiest borrowers since December 2008, according to the Bank of America Merrill Lynch U.S. Corporate & High Yield Index.

Even after a Fed scaleback of stimulus efforts triggered the first annual decline for investment-grade corporate bonds since the crisis, shorter-term notes remained both a haven from rising long-term rates and a source of incremental yield for money-market investors.

While the broader market delivered a 1.45 percent loss to investors, notes with maturities of one to five years gained 1.56 percent, Bloomberg index data show. Short-duration mutual fund assets swelled by $65 billion to about $300 billion, according to Morgan Stanley, citing data from the Investment Company Institute.

Money Funds

Dollars that would normally be parked in money-market funds have been funneled into “short duration funds to earn at least a little bit of yield,” Hans Mikkelsen, the head of U.S. investment-grade credit strategy at Bank of America Corp. in New York, wrote last month in a report. “That reveals significant interest-rate risk in short duration” with the clear threat of outflows from mutual funds, exchange-traded funds and other investment vehicles, he wrote.

“There is a potential for losses in the short term,” said John McClain, a Boston-based senior vice president at Standard Life Investments, which oversees more than $300 billion. “If rates are rising for the right reason, meaning the economy is doing better, then you could definitely see money flowing out of corporate bonds to a degree and into equities or riskier asset classes.”

Luring Pensions

That probably depends on the pace at which the Fed curtails its unprecedented stimulus aimed at supporting economic activity by holding down borrowing costs. Policy makers led by Chair Janet Yellen may end the central bank’s bond-buying program before year-end and lift the benchmark federal funds target rate by 2015.

An annual loss for the short-term portion of the fixed- income market would mark only the second time since 1977 that the debt has failed to deliver gains, according to Bank of America Merrill Lynch index data. The securities lost 4 percent in 2008.

The debt returned 0.9 percent in the first three months of the year, trailing the 6.5 percent gains for securities maturing in 15 years or more, the index data show.

The later-maturing debt is luring back investors that had scaled back their fixed-income holdings in recent years as they seek to match long-term obligations. Investment-grade corporate debt due in 10 years or longer now yields about 4.8 percent, compared with 4.4 percent a year ago, Bloomberg data show.

Corporate-bond ownership by insurance companies, which account for 19 percent of the market, and pension funds remain close to historical lows, according to Morgan Stanley. Broker- dealer holdings are down by almost $200 billion relative to pre- crisis levels.

“We’re potentially at a transition point now where, if we are going to move into a world of higher yields, the pension fund or the insurance company will be motivated to do more investment in fixed income and credit,” Morgan Stanley’s Mahadevan said.