As we explained in April, the bond market would be vulnerable to a sell-off when interest rates moved higher. As rates rose in May and June, we saw record outflows of funds from the bond market and bond prices declined sharply. High-yield bond funds reported their third highest outflow on record in mid-June following comments from the Federal Reserve regarding the potential of higher interest rates. Given the enormous flow of capital into bonds over the past 30 years, this initial reaction is likely a mere trickle to what could become a rout in the bond market.
While investors have experienced gains in bonds for nearly three decades, all indicators suggest that is changing. As the chart in Figure 5 shows above, over $3 trillion flowed into bonds between 1991 and 2011.
In 1994 and 1999, when bonds experienced selling pressure because of rising rates, the value of the typical bond fund saw outflows of about 10% and declined about 10% in value. That was an orderly decline. Today, the share of corporate bonds in mutual funds and ETFs has increased dramatically from those “orderly” declines, suggesting the stage may be set for a more chaotic, “disorderly” decline in bonds if or when rates move higher. Any rallies now may be an opportunity to reconsider your intermediate and long duration bond holdings.
Discuss your bond holdings with your financial advisor. Not all bonds are alike and different types will behave differently in any bond sell-off. It is important to know what you own and how it may react in a rising rate world.
David Menashe is a Senior Vice President and Wealth Management Advisor, and Bruce Morley is a First Vice President and Wealth Management Advisor, for Merrill Lynch, Pierce, Fenner & Smith Incorporated, a registered broker-dealer, member SIPC, and a wholly owned subsidiary of Bank of America Corporation. Investment products are not FDIC insured, are not bank guaranteed, and may lose value. (858.381.8113)
Photography by Andy Templeton