Investors who bet heavily on Treasuries took a beating in 2013, and as the Fed winds down its bond buying, they face the risk of a second straight losing year, something that has not happened in four decades.
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Portfolio managers at large U.S. bond funds are, however, a bit optimistic. They say the most violent adjustment in the bond market has already happened, even though bond yields should rise a little more in 2014 as the Federal Reserve reduces its massive stimulus program.
Some analysts have long foreseen a protracted rise in yields after nearly 30 years of steadily falling rates. But the consensus among managers is that benchmark 10-year Treasury yields should peak around 3.5 percent this year, up from 3 percent now and remain otherwise in a tight range. A 50-basis point rise would pale against the 125 basis-point rise in yields in 2013.
"We don't expect another aggressive bond sell-off. I think even with the Fed tapering, policy accommodation will remain pretty high in 2014," said Jennifer Vail, head of fixed-income research at U.S. Bank Wealth Management in Portland, Oregon.
Another surge in yields would mean more misery for bond investors, including Bill Gross, who runs the world's biggest bond fund, the Pimco Total Return Fund <PTTRX.O>. That fund suffered its first annual loss since 1999, a negative return of nearly 2 percent.
But if the rise in yields is moderate and orderly, Gross and other investors who are bullish on Treasuries would have plenty of time to adjust their portfolios to reduce losses and take on bets in other bond sectors.
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Fund flows into Treasuries in 2013 were slower than any other year since 2000. Pension funds, insurance companies, college endowments and foreign investors could find greater appeal in Treasuries as yields edge higher in coming months, but retail investors might still shy away from bond funds, particularly given the buoyant outlook for equities.
"Any zig-zag in rates will have retail investors very nervous," said Quincy Krosby, market strategist at Prudential Financial in Newark, New Jersey, which oversees $1 trillion in assets.
The yield on 10-year Treasury notes was 2.99 percent on Friday, roughly a two-and-a-half-year high and nearly double what it was a year ago. Increases in yields accelerated in May, after Fed Chairman Ben Bernanke suggested before a congressional panel that the Fed might consider shrinking its quantitative easing before year-end.
Recent data has supported the view of a somewhat slow-growing U.S. economy, which will likely keep the Fed tapering gradually and cautious about raising interest rates.
"What the market is adjusting to is a little faster growth and less Fed buying. It could be another year of negative returns," said Gemma Wright-Casparius, portfolio manager at Vanguard, the top U.S. mutual fund company.
The 10-year yield has stabilized above 3 percent as investors await the payrolls report for December to determine if the economy is strong enough for Fed to quicken its stimulus reduction and possibly raise rates before late 2015.
On Friday, Richmond Fed President Jeffrey Lacker said if the economy strengthens more than expected this year, he could see the Fed increasing rates in later 2014.
With blue chip stocks powering into record territory, investors have been moving away from bond funds since June. Still, bond funds were able to report $29 billion in inflows in 2013, although they were the weakest since 2000, according to Lipper, a unit of Thomson Reuters.
In fresh quarterly forecasts released last month, the Fed's outlook on growth of gross domestic product was in a range of 2.8 percent to 3.2 percent in 2014, a tad stronger than what Wall Street expects.
"There's a fair amount of economic optimism priced into these yields," said Bill Irving, a Merrimack, New Hampshire portfolio manager for Fidelity Investments, the No. 2 U.S. mutual fund company. "I don't see the 10-year yield going much higher from here. We have to see more surprisingly strong data."
The threat to this view of a moderate yield rise would come if growth, perhaps driven by the U.S. energy production boom and the impact of higher home and stock prices on consumer spending, were to rise to 3.5 percent to 4.0 percent. That would in turn put pressure on the Fed to pull back on its bond buying more quickly and lead to concerns that the Fed would raise short-term interest rates sooner than the late 2015 currently expected. All that could force bond yields significantly higher than 3.5 percent.
Since the Fed began purchasing Treasuries and mortgage-backed securities, its balance sheet has ballooned by more than $1 trillion to near $4 trillion since late 2012.
On December 18, Fed policymakers said the U.S. central bank will purchase $75 billion in bonds in January, $10 billion less than the monthly pace at which it had been buying.
BOND BEARS COMETH?
A lousy year for Treasuries is rare. Even including a dismal 2013, the Treasuries market has posted annual losses only four times since 1973, according to Barclays, and has never experienced back-to-back losing years.
In 2013, Treasuries suffered a 2.75 percent loss, while the broader U.S. bond market declined 2.02 percent, the biggest annual drop since 1994, according to indexes that Barclays compiles.
The biggest yearly rise in benchmark Treasuries yields in four years disrupted the housing market this past summer, but it has proven to be only a hiccup for the economy.
U.S. growth had recorded its best three months in nearly two years this autumn, while Wall Street booked its biggest annual gain in more than 15 years.
(Reporting by Richard Leong)