Before Bailing on Bonds, Try These Ideas Instead

Getty Images

What looked like the beginning of the "Great Rotation" in retrospect may just turn out to be the "Great Overreaction."

Bond markets have been in a tizzy ever since Federal Reserve Chairman Ben Bernanke indicated two weeks ago that the central bank may be turning course to tighter monetary policy.

Interest rates surged on Bernanke's comments, and panicky investors yanked, by one count, nearly $80 billion out of bond mutual and exchange-traded funds in June. That has generated speculation that the Great Rotation theme of money flowing from stocks and bonds may have begun.

(Read More: 'Unprecedented' $80 Billion Pulled From Bond Funds)

But as the dust settles and Wall Street realizes that the Fed exit probably will be slower than Bernanke indicated, many fixed income pros are treating the jump in yields as an opportunity.

"You've seen a big overreaction to the Federal Reserve and the policy changes that they've had," Michael Lillard, managing director and chief investment officer for Prudential Fixed Income, said at a briefing last week in which the firm set out its second-half forecast. "That's created a lot of value both in the rate space as well as in the credit space."

Among Lillard's best ideas for the second half are banks; structured products such as collateralized mortgage-backed securities; and emerging-market debt in countries like Mexico that will be less susceptible to gyrations in commodity prices.

As for an overarching theme, Lillard echoes the belief of others in fixed income that the Fed easing back on its $85 billion a month bond-buying program and the ultimate gradual increase of its target funds rate should be viewed as a vote of confidence for economic growth and thus market-positive.

Conversely, should the Fed be overly optimistic, that would keep rates low while growth continues to lag.

"The core of the message that they have is that quantitative easing is an emergency tool, so we do QE when there's an emergency," he said. "They're looking at that improvement and what they're saying is the downside risks to the economy have diminished and the emergency is over."

If the fear of QE ending too soon is overdone, then that sets up opportunities for a market that has seen yields in some cases surge more than 1 percentage point in a month.

(Read More: Why All the Bond Selling Hysteria May Be Overdone)

Michael Cloherty, head of U.S. rates strategy at RBC Capital Markets, sees an opening for playing a widening spread between the five-year and 10-year Treasury notes. The trade, which uses derivatives to capture income growth when spreads widen, is used most often when investors expect falling yields.

"The most obvious overshooting in the Treasury market has been the degree of tightening priced into the front of the curve," Cloherty said. "The Fed will need to be very gentle in the early phases of tightening, as none of us know if any structural weaknesses will have developed after nearly seven years at zero rates."

The selloff has spread well beyond Treasurys.

Municipal bond investors have been bailing in droves, pulling $4.5 billion from the market last week alone, according to Thomson Reuters.

That's been in large part because of fears of a Fed exit that may not even be applicable to the muni market.

"While municipals have been cheapening in empathy with Treasurys, it is worth noting that this market has never had direct support from the Fed," Citigroup muni analyst George Friedlander said in his weekly update.

"Thus, we believe municipal investors need not worry about a fundamental re-evaluation of the market even after the Fed embarks on its tapering schedule for asset purchases."

Friedlander's best ideas include single-A-rated taxable munis, long-dated high-grade municipals and a switch out of banks (contrary to Lillard's strategy) and industrials into prepay gas and corporate-backed munis.

(Read More: Junk Bonds No Longer Look So Good)

To be sure, though, the road to rate stability is likely to be rocky.

Investors didn't seem to know what to make of Monday's sharp stock market rally that came on the back of an economic reading from the Institute for Supply Management that was better but nothing spectacular.

Until the next round of big data releases pass—the critical nonfarm payrolls report comes Friday—investors should be careful about how much risk they are willing to take on future policy decisions, said George Goncalves, head of U.S. rates strategy at Nomura Securities.

He points out that bond and equity fund flows are about equally positive for the year, indicating that any "Great Rotation" from bonds into stocks has yet to begin.

"The key question on investors' minds is whether the current and much quicker fund outflow ... will continue, or have we moved into a new paradigm where it's the beginning of the end of nonstop bond fund inflows given that the Fed may be taking away its support," he said in a note.

(Read More: Hedge Funds Shift to Stocks, in Time for Pullback)

Goncalves said his portfolio "remains very lean into and out of quarter-end," with plays on a spread widener on the 30-year bond, as well as a steepener between the 10-year note and 30-year inflation breakevens.

He worries that the flow exodus could continue and the Fed might get behind the curve.

"In the grand scheme of things, the total outflow is small compared with the size of the industry, but it's been the pace and reversal of inflow trends that has broader market participants worried," Goncalves said. "We are a bit perplexed why there hasn't been a greater focus on what is happening in the mutual fund space by the Fed."

—By CNBC's Jeff Cox. Follow him @JeffCoxCNBCcom on Twitter.