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With the recent spate of articles, it seems like money managers in other bond categories are sensing blood and descending like sharks to get at that $80B up for geabs in the floating rate category.
Yeah, I've noticed that, too. It's typically around 2-4% of assets (though I've seen it as high as 10% in some low duration funds). I wonder if they're using the allocation as a substitute for ST/short duration bonds, to give a slight goose to their fund's yield. And if it's called away from them, c'est la vie, there's always another comparable reissue around ... or something like that.....
The author points out what has been long known. When a loan is designed to allow early payment by borrowers they will do so as long as rates are trending down and they can refinance at lower and lower rates. This negatively impacts the level of income lenders receive. This "pre-payment risk" is acknowledged by GNMA funds in their prospectuses, as mortgage holders are notorious for refinancing at lower rates. I'd imagine floating rate funds also so warn.
The beauty of the floating rate funds is that the lender (in case you the fund owner) is not locked-in to a fixed rate. While you suffer as rates fall, you should do much better when rates rise. In the later case, traditional bond holders suffer as investors flee to higher paying instruments and sell previously issued bonds at discount - driving down bond values for everyone.
If there's anyone here who's consistently called the interest rate picture accurately over the past 3 years please come forward, My sense is even the experts are mystified. Where's that great "bond bust" so widely predicted for 2-3 years now? The ten-year has bumped up from its bottom below 1.5% couple years ago to only around 2.6% today. A "bust" by no means. NBR reports that 30 year mortgages are at a one-year low today at just a bit over 4%.
Bottom line? Floaters are one type of insurance against a rising rate environment if and when it comes. Like all fixed income investments, they have their attributes and liabilities. But, don't expect anyone to stand on the corner and ring a bell on the exact day rates begin a sharp irreversible trend upward. (Just my overly-wordy two cents:-)
@hank, what you are saying is absolutely correct and the rationale as to why $80B flowed into the floating rate category.
But there is a problem that has to do with the bond market. Bonds (at least at the volumes that funds deal with) don't trade like equities in a large liquid exchanges. At best, it is like OTC and at worst like real estate sales with a broker in between bringing a buyer and seller together. Settlements can take weeks in some cases, not the instant settlements that happen in most equities.
Normally, this is not a problem but when huge amounts of money flows into a category, sometimes more than the supply, it distorts the market in that category. Bonds get issued that would be difficult to sell before the term. This, by itself, may not become a problem. But a shock to the system leading to massive redemptions in funds can lead to a situation where the supply overwhelms demand and as in equities where demand dries up, the prices of the bonds plummet assuming you can even sell it.
People seem to think the coupon rates and prices are tied in a strict formula. It is not true any more than equity prices are tied to some measure such as P/E ratio. It is the price discovery in normal markets that drives the prices to that relationship with the rates. All bets are off when liquidity dries up.
Some people are warning that the possibility of such a potential exists now in floating rates. This is a systemic risk in the category unrelated to interest rate movements. Any number of things can trigger massive outflows. It is possible that some of the people warning this have a vested interest in driving some of the money invested there into their own categories. Others are warning that the same situation exists in high yield bonds at the moment.
The point is that the interest rate risks and issuer credit risks are not the only risks inherent in bonds, especially when there are large flows of money even if there is a good rationale for the category as you are thinking of.
Absolutely true. (I had to re-read article to catch his second point.) Thanks.
Yes - lower rated/unrated bonds, including high yield bonds, constitute an illiquid market. And it's easy for many (including myself) to overlook. Fund prospectuses do a good job warning of this. But who reads them?
The illiquidity becomes an issue usually during a market "rout" as you aptly suggest - when buyers flee the market. However, my cursory past readings suggest the bank loan paper is a bit more credit-worthy than typical corporate high yield - primarily because of a higher prescribed order of repayment during bankruptcy proceedings. So, during a rout, I'd still prefer to be in the bank notes rather than corporate low or unrated paper.
Routs like this are exceedingly rare - but they do happen. The last was during the '08 market crash. One poorly run and over-extended open-end high yield bond fund managed to loose around 80% of its value in a year's time. (BTW: Floating rate funds held up somewhat better than high yield funds during that period.)
Managers can do much to reduce risk to their shareholders through: (A) their own high quality independent credit research (B) holding offsetting debt like long term Treasuries and high quality corporates (C ) Keeping ample cash reserves to meet redemptions (D) Restricting "hot money" flows in and out of the fund or closing completely when warranted.
So ... your fund is only as good as your manager. Let's hope you gave a good one.
Managers can do much to reduce risk to their shareholders through: (A) their own high quality independent credit research (B) holding offsetting debt like long term Treasuries and high quality corporates (C ) Keeping ample cash reserves to meet redemptions (D) Restricting "hot money" flows in and out of the fund or closing completely when warranted.
So ... your fund is only as good as your manager. Let's hope you gave a good one.
there is really not much managers of illiquid asset classes in the open-end funds can do. once the outflows start, they have to raise cash for the daily liquidity funds by selling loans (hi-yield, mortgages, blah-blah securities) into a declining market causing further declines. the thinner the trading volume (on all credit instruments and micro caps) the more the price is affected by the flows. there was a blip last year after the tapergate when the loans lost 5-6 percent in one month -- mostly due to the outflows. the less liquid hedge funds or close-end funds will also be affected as security pricing impacts the entire asset class, but because they won't need to sell at the fire sale prices (i assume they maintain enough assets to cover their leverage, which is not always the case) they might even pick up some good stuff on the cheap. the mark-to-market will be brutal, but the recovery will be much swifter than that of the mutual funds who will realize their losses.
i am enjoying the high yield party just as the next gal. i just know that the question is not how or if this ends, but only 'when'. the amount of money that has flown into credit instruments has no precendent in history. the narrow exit door will lead to the bloodshed. personally, i still prefer high yield bonds and non-agency MBS to the overpriced and floored loans.
best, fa
ps i like how ted [with hot biotech] silenced catch's weekly bond updates -- your typical hare and turtle story..
You noted: "ps i like how ted [with hot biotech] silenced catch's weekly bond updates -- your typical hare and turtle story.."
I am not clear as to what you are indicating with this statement.
The weekly reports were stopped in January, 2013 to begin several projects; both physical and personal. While the reports were fun to construct; I don't miss the time spent, and the time is now better focused on the family.
@hank My original reply was to your past tense statement/question.
This new consideration is a whole different beast, eh? Looking forward.
Kindly lay-out for us mere mortals where the 10 year Treasury will be on the following dates: July 4, 2014 October 1, 2014 December 31, 2014 June 1. 2015 December 31, 2015 June 1. 2016 December 31 2016
I suspect the 10 year rate to not change much from the 2.6% area currently in place. While I have reports in Michigan from folks I know about increased spending in some construction areas, 30% higher than 2013; I still feel the Fed will have to be very helpful with rates for a few more years. Gotta keep rates low to attempt to help folks with mortgage and auto loans. 'Course, low rates will continue to destroy monies and purchasing power for the many who will not gamble in the equity or bond markets. This large group will maintain their CD's. A Catch-22 does exist for many economies. Low rates being in place from central bank actions to "help" one group(s) of folks, while causing damage to another group of folks who have saved money, are conservative with their money and will continue to have their monies damaged from inflation. Tax revenue is lower, too; in line with the poor yield from CD related investments. Well, there surely is much more related to this broad area, eh? The big/easiest money has likely been made from most bonds since 2008, but too many economic weak areas remain. I feel yields will remain low for a variety of reasons.
TIPs bonds funds or etfs may continue to offer a decent and somewhat conservative return from earlier this year and going forward. As always, one has to be flexible and pay attention.
Gotta get outside work finished before the storms arrrive.
Comments
The beauty of the floating rate funds is that the lender (in case you the fund owner) is not locked-in to a fixed rate. While you suffer as rates fall, you should do much better when rates rise. In the later case, traditional bond holders suffer as investors flee to higher paying instruments and sell previously issued bonds at discount - driving down bond values for everyone.
If there's anyone here who's consistently called the interest rate picture accurately over the past 3 years please come forward, My sense is even the experts are mystified. Where's that great "bond bust" so widely predicted for 2-3 years now? The ten-year has bumped up from its bottom below 1.5% couple years ago to only around 2.6% today. A "bust" by no means. NBR reports that 30 year mortgages are at a one-year low today at just a bit over 4%.
Bottom line? Floaters are one type of insurance against a rising rate environment if and when it comes. Like all fixed income investments, they have their attributes and liabilities. But, don't expect anyone to stand on the corner and ring a bell on the exact day rates begin a sharp irreversible trend upward. (Just my overly-wordy two cents:-)
Howdy,
You noted: "If there's anyone here who's consistently called the interest rate picture accurately over the past 3 years please come forward?"
.....I have my hand raised...............
Take care,
Catch
But there is a problem that has to do with the bond market. Bonds (at least at the volumes that funds deal with) don't trade like equities in a large liquid exchanges. At best, it is like OTC and at worst like real estate sales with a broker in between bringing a buyer and seller together. Settlements can take weeks in some cases, not the instant settlements that happen in most equities.
Normally, this is not a problem but when huge amounts of money flows into a category, sometimes more than the supply, it distorts the market in that category. Bonds get issued that would be difficult to sell before the term. This, by itself, may not become a problem. But a shock to the system leading to massive redemptions in funds can lead to a situation where the supply overwhelms demand and as in equities where demand dries up, the prices of the bonds plummet assuming you can even sell it.
People seem to think the coupon rates and prices are tied in a strict formula. It is not true any more than equity prices are tied to some measure such as P/E ratio. It is the price discovery in normal markets that drives the prices to that relationship with the rates. All bets are off when liquidity dries up.
Some people are warning that the possibility of such a potential exists now in floating rates. This is a systemic risk in the category unrelated to interest rate movements. Any number of things can trigger massive outflows. It is possible that some of the people warning this have a vested interest in driving some of the money invested there into their own categories. Others are warning that the same situation exists in high yield bonds at the moment.
The point is that the interest rate risks and issuer credit risks are not the only risks inherent in bonds, especially when there are large flows of money even if there is a good rationale for the category as you are thinking of.
Great to hear, Catch!
Kindly lay-out for us mere mortals where the 10 year Treasury will be on the following dates:
July 4, 2014
October 1, 2014
December 31, 2014
June 1. 2015
December 31, 2015
June 1. 2016
December 31 2016
Thanks so much.
Absolutely true. (I had to re-read article to catch his second point.) Thanks.
Yes - lower rated/unrated bonds, including high yield bonds, constitute an illiquid market. And it's easy for many (including myself) to overlook. Fund prospectuses do a good job warning of this. But who reads them?
The illiquidity becomes an issue usually during a market "rout" as you aptly suggest - when buyers flee the market. However, my cursory past readings suggest the bank loan paper is a bit more credit-worthy than typical corporate high yield - primarily because of a higher prescribed order of repayment during bankruptcy proceedings. So, during a rout, I'd still prefer to be in the bank notes rather than corporate low or unrated paper.
Routs like this are exceedingly rare - but they do happen. The last was during the '08 market crash. One poorly run and over-extended open-end high yield bond fund managed to loose around 80% of its value in a year's time. (BTW: Floating rate funds held up somewhat better than high yield funds during that period.)
Managers can do much to reduce risk to their shareholders through: (A) their own high quality independent credit research (B) holding offsetting debt like long term Treasuries and high quality corporates (C ) Keeping ample cash reserves to meet redemptions (D) Restricting "hot money" flows in and out of the fund or closing completely when warranted.
So ... your fund is only as good as your manager. Let's hope you gave a good one.
http://blog.alliancebernstein.com/index.php/2013/03/27/the-sand-continues-to-shift-in-high-yield-bank-loans/
a very good primer on the current market. buyer beware.
i am enjoying the high yield party just as the next gal. i just know that the question is not how or if this ends, but only 'when'. the amount of money that has flown into credit instruments has no precendent in history. the narrow exit door will lead to the bloodshed. personally, i still prefer high yield bonds and non-agency MBS to the overpriced and floored loans.
best, fa
ps i like how ted [with hot biotech] silenced catch's weekly bond updates -- your typical hare and turtle story..
Howdy,
You noted: "ps i like how ted [with hot biotech] silenced catch's weekly bond updates -- your typical hare and turtle story.."
I am not clear as to what you are indicating with this statement.
The weekly reports were stopped in January, 2013 to begin several projects; both physical and personal. While the reports were fun to construct; I don't miss the time spent, and the time is now better focused on the family.
Take care of you and yours,
Catch
My original reply was to your past tense statement/question.
This new consideration is a whole different beast, eh? Looking forward.
Kindly lay-out for us mere mortals where the 10 year Treasury will be on the following dates:
July 4, 2014
October 1, 2014
December 31, 2014
June 1. 2015
December 31, 2015
June 1. 2016
December 31 2016
I suspect the 10 year rate to not change much from the 2.6% area currently in place. While I have reports in Michigan from folks I know about increased spending in some construction areas, 30% higher than 2013; I still feel the Fed will have to be very helpful with rates for a few more years. Gotta keep rates low to attempt to help folks with mortgage and auto loans. 'Course, low rates will continue to destroy monies and purchasing power for the many who will not gamble in the equity or bond markets. This large group will maintain their CD's.
A Catch-22 does exist for many economies. Low rates being in place from central bank actions to "help" one group(s) of folks, while causing damage to another group of folks who have saved money, are conservative with their money and will continue to have their monies damaged from inflation. Tax revenue is lower, too; in line with the poor yield from CD related investments.
Well, there surely is much more related to this broad area, eh?
The big/easiest money has likely been made from most bonds since 2008, but too many economic weak areas remain. I feel yields will remain low for a variety of reasons.
TIPs bonds funds or etfs may continue to offer a decent and somewhat conservative return from earlier this year and going forward. As always, one has to be flexible and pay attention.
Gotta get outside work finished before the storms arrrive.
Take care,
Catch