Bond-Picker's Market Looms For Fixed-Income Investors

While it has become increasingly difficult to be a stock picker in the equity markets, the massive rally in fixed income may be giving way to a bond-picker's market.

Savings Bonds
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Savings Bonds

High levels of correlation—or the tendency of asset classes to move in the same direction—have made being selective in stocks less relevant. The Standard & Poor's 500 components have been moving in sync about three-quarters of the time, and in a broader sense pretty much everything, be it stocks, bonds, commodities or currencies, has been going up and down together.

But as analysts get increasingly skeptical of the turbo-charged bond market rally, they think investors fond of simply buying bond funds will have to get choosier in the future.

"The retail investor is going to have a very unhappy ending. As this thing gets more and more outsized, it's going to be bad," Marilyn Cohen, CEO of Envision Capital Management and author of "Bonds Now." "That's why I like individual bonds, but you have to be selective."

Cohen is a bonds advocate but believes investors have gotten too aggressive buying funds instead of looking at individual issues.

Net taxable bond fund inflows, excluding exchange-traded funds, for the $2.6 trillion industry were a staggering $20.5 billion for the month ending Sept. 17, according to Lipper data. Including ETFs, the number swelled to $23.4 billion.

"That's where the bubble is. They have just gorged themselves of bond funds of all types," Cohen says. "We cannot deploy the cash that's coming in fast enough. At some juncture it's going to catch up to the bond funds because they're going to have bonds that are called, tendered or matured. They're not going to be able to do it for much longer at this pace."

It's not like investors don't have choices.

There already has been $18 billion in corporate bond issuance this week, coming after successive weeks of $35.7 billion and $30.2 billion in issuance, according to data from Bank of America Merrill Lynch Global Research.

Institutional investors are snapping up huge quantities of high-grade corporate bonds, giving way to historically low yields and coupons.

For the second quarter, corporate bond issuance fell to $229 billion from $432 billion in the first quarter. But that appears to be changing, with a likely flood of new issuance coming on and investors needing to be prepared.

With yields so low, the best opportunities for income could be coming from mid- and lower-grade bonds, making choosiness even more important, says Robert Tipp, chief investment strategist at Prudential Fixed Income in Newark, N.J.

"We have over 30 credit analysts because of a need, even in normal times, to be selective," Tipp says. "Certainly in an environment of lower yields and tighter spreads in high-quality bonds, that is case as much as ever."

"They've got to decide what they're looking to accomplishy in this market, what their goals are and what their objectives are, and then look. ." -Hennion and Walsh, Bill Walsh

Cohen says high-yielding bonds from companies such as Macy's and Ford Motor offer attractive yield and reasonable assurance that the issuers will not default.

"There are some bonds that everybody and their grandmother want to own, and they've become much more overvalued than others," she says. "Many companies' capital structures are like bowls of spaghetti. Keep it simple and don't work backwards like so many investors do."

The latter comment refers to simply hunting for yield first and then looking at the company last.

The search for yield contains various perils outside of simple defaults. Buyers can get hammered with loss of principle by bonds that get called early and pay lower on the face value than the initial investment. Investors may not have made enough money on the biannual coupon payments to make up the difference, leading to actual money losses on the early-called bonds.

For that and other reasons, many bond pros are turning their clients toward municipal bonds, even in light of the struggles that many local governments face.

Again, the key is selectivity and paying attention to what types of municipals are being bought.

"Individual investors definitely have to pay attention to what they're buying," says Bill Walsh, president of Hennion and Walsh in Parsippany, N.J. "They've got to decide what they're looking to accomplish in this market, what their goals are and what their objectives are, and then look. We've seen very strong demand in municipals."

Walsh recommends triple-A rated municipals with a focus on general obligation bonds.

But Cohen worries that investors have not been selective and may have just created a new credit bubble from the ashes of the old one.

"People just need to be cautious. They're not sitting on the sidelines, which I can understand," she says. "It just looks like no lessons were learned from the credit crisis. People have licked their wounds, gotten out of equities and gone into the bond market with abandon."