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Bond Investors Were ‘in Denial’

Chris Ratcliffe | Bloomberg | Getty Images

Bond investors that banked on unlimited quantitative easing were "in denial", according to one asset manager, explaining the "violent" market reaction to the Federal Reserve's warning that its bond purchasing program could soon be scaled back.

(Read More: Bernanke Is Doing the Right Thing: Trichet)

"A lot of bond managers, in the name of 'don't fight the Fed', have been assuming that the unlimited liquidity will go on forever. I think they were in denial about what the Fed has said, but it kind of hit them between the eyes this time," said Jim McCaughan, president of global asset management at Principal Financial Group on the sidelines of the FundForum conference in Monaco.

"Some people are using the phrase the 'new normal'. I tend to use the phrase 'the return-to-normal', which is the market setting rates," he added.

Global bond yields rose sharply after Fed Chairman Ben Bernanke said last week that the central bank could reduce its $85 billion monthly bond purchases by year-end, if the U.S. economy continues to improve. U.S. 10-year Treasury yields neared 2-year highs on Bernanke's words and stock markets have had volatile swings. The Dow Jones and the S&P 500 have both fallen 5 percent from market peaks.

McCaughan said fund managers could take a big hit when interest rates finally rise.

"The carry trades won't be as easy or as profitable as they have been in the past — many funds, such as insurance funds, just have too much duration, and they really hurts when rates kick up," he said.

Charles Beazley, the CEO of Nikko Asset Management, agreed that many market participants had invested "on the wrong side of the trade". He added, though, that the current level of market turmoil was short-term, and that it would calm down as investors start to ascertain where risk premiums should be.

"I am not a Fed watcher, but it is clear that the end [of QE] is in sight, which I think is a perfectly logical process. But I think there are many people are invested on the wrong side of the trade, which is what has caused the volatility," Beazley told CNBC at FundForum.

However, some fund managers are uncertain how to position their portfolios going forward. Lucio Soso, portfolio manager at Bellevue Asset Management, said he held too many bonds but did not know what do next.

"I have lost 6 percent this month; I am not sure what to do. I need to reduce the bonds in my portfolio, but I don't have the guts to buy anything at the moment," Soso said.

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