Analysis: Big inflows into bonds undercut the "Great Rotation"

Fears of a rush for the exits from the U.S. bond market have been greatly exaggerated.

Even as the fixed-income sector grapples with a rare negative start to the year, many of the biggest and widely followed bond firms are still attracting new cash to their flagship funds. And it is not expected to stop any time soon.

"I think the demand is there because many investors, especially mom-and-pop investors, still want income and, equally important, have been burned twice on equities," said Jeffery Elswick, director of fixed income at Frost Investment Advisors, LLC, which manages over $9 billion.

"They lost so much money, like in the double-digits, during the tech bust (2000-2002) and credit crisis in 2008 - and don't want to go through that again," he said.

The Federal Reserve's massive bond-buying program, $85 billion a month of U.S. Treasury debt and residential mortgage bonds, has driven bond prices higher and pinned their yields, which move in the opposite direction, near record lows.

That has led many market experts to warn there was a much greater risk of significant losses - as yields eventually return to more normal levels - than any further gains in the bond market. They therefore predicted 2013 would be the year of a large-scale investment shift market many dubbed "The Great Rotation" - a tilting of pension and insurance funds' long-term asset mix back towards equities from heavy weighting in bonds.

Yet big names like Pacific Investment Management Co (PIMCO), DoubleLine, Loomis Sayles and TCW have seen their main bond funds take in an aggregate total of roughly $5 billion during January and February. Vanguard's indexed Total Bond Market portfolios have received over $5.6 billion for the same period, according to the latest data provided by Morningstar.

More broadly, while U.S. funds that invest in stocks have gained $78.88 billion in new cash so far this year amid the U.S. stock market's run-up, taxable bond mutual funds have garnered roughly the same - $76.41 billion, according to data from Thomson Reuters' Lipper service.

These inflows belie the notion that "The Great Rotation" has taken hold this year.

"The idea of a 'Great Rotation' into stocks from bonds appears to be a somewhat naive justification of the bullish case for equities for those who have not grasped the magnitude of the Federal Reserve's impact on the market," said Bonnie Baha, head of Global Developed Credit at DoubleLine Capital LP, which manages more than $56 billion in Los Angeles.

Too much emphasis has been placed on the widespread prediction that record-low bond yields will prompt investors to rotate out of bonds and into stocks during 2013, Baha said. Equities have gained strongly this year on increasing confidence in the U.S. economy and financial markets, while bond prices are being supported by U.S. central bank purchases.

The reallocation to equities has apparently come at the expense of money market funds, noted Larry Jeddeloh, chief financial officer of the TIS Group, which produces the Market Intelligence Report. Those funds have suffered outflows of $82.5 billion so far this year.

Indeed, the Fed's program to suppress interest rates has triggered a massive yield hunt among investors. That has translated into strong demand for investment-grade corporate debt and high-yield bonds, also called junk bonds because they carry below-investment-grade ratings from Standard & Poor's and Moody's Investors Service.

"I think there's a tug of war going on," DoubleLine's Baha said. "This is likely to be a low volatility year for bonds with all the Fed bond buying. I don't think you will see a wholesale exit from diversified bond portfolios."

The yield on the benchmark 10-year Treasury note, which popped above 2 percent in February, had declined to 1.76 percent by the close on Thursday. That is despite relatively strong economic data, a recovering housing market and gains in U.S. stocks that have taken indexes to record highs.

Geopolitical risks have also led investors to their favorite safe haven of Treasuries. On Wednesday, Treasuries gained on news the Pentagon was sending a missile defense system to Guam in the coming weeks and remarks by Defense Secretary Chuck Hagel that North Korea posed a "real and clear" danger.


Bonds did suffer a quarterly loss to start the year. The Barclays U.S. Aggregate Bond Index registered a total return of negative 0.12 percent in the first quarter, only its second down quarter since the financial crisis, though most big-name bond funds turned in a slightly positive total return.

TCW funds easily surpassed the benchmark Barclays Aggregate, posting a first-quarter return of 1.12 percent, bringing its 12-month return to 10.37 percent. That performance stems from its bet on so-called non-agency mortgages, or residential mortgage bonds not guaranteed by the likes of Fannie Mae or Freddie Mac.

Those have gained thanks to the Fed's massive bond-buying purchases, which have helped support risk assets including non-agency mortgage-backed securities(MBS). And with the housing market recovering, managers like TCW correctly bet that there would be more profit and less risk in buying private-label MBS-backed debt.

The fund's manager, Bryan Whalen, said he expects these bonds to offer loss-adjusted returns in the 7.5 percent to 9 percent range. Last year, TCW also began shifting into floating-rate assets that had been less in demand given the Fed's intention to keep its target interest rate low through mid-2015.

For its part, the DoubleLine fund, which is also exceeding the index with a return of 1.27 percent during the first quarter, has used a combination of government-guaranteed securities, mainly agency MBS and some Treasuries, and credit securities, mainly private-label, residential mortgage-backed securities with some commercial MBS. DoubleLine's 12-month return is now 7.37 percent, as of the end of March.

When corporate credit and equity prices have fallen, be it due to macro risks such as European debt crisis, heightened fears of economic weakness in the U.S., or worries over budget deficit issues, U.S. government-guaranteed issues such as agency MBS and Treasuries have rallied.

Conversely, when credit prices rally because of growing confidence in the economy, non-agency MBS and commercial MBS participate in the gains. The fund's low duration and healthy yield also buffers the overall portfolio from swings or volatility in prevailing interest rates.

The PIMCO Total Return Fund, run by PIMCO founder and co-chief investment officer Bill Gross, is also outperforming its benchmark.

The fund has gained 0.60 percent so far this year, as of March 31, outperforming the Barclays Aggregate, and for the full year, the PIMCO portfolio's 12-month return of 7.92 percent is easily beating the one-year return of the Barclays index at 3.77 percent.

Gross's Total Return Fund has been overweight in some credits such as non-U.S. developed markets and emerging markets. He has also shortened the fund's duration thereby reducing the portfolio's risk to rising interest rates. As of February 28, the fund's effective duration stood at 4.54 years, down from 4.77 years at the end of last year.

Gross said on Twitter in March that five-year and shorter maturities will "do best based on continuing policy rate.

(Reporting By Jennifer Ablan; Editing by Dan Burns and Leslie Gevirtz)