THE BLOG
09/09/2013 02:10 pm ET Updated Nov 09, 2013

Surviving the Bond Exodus

Are we at the beginning of a Bond Exodus? If so, how do we keep from being crushed? For answers, I turned to bond expert, Kathy Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research.

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We both took time in a deserted New York City office building on the Friday before the last, long summer holiday weekend (August 30, 2013), to discuss something that affects every professional, but puts most people to sleep! It's rather refreshing to see an expert who beams as she recalls staying up late to read Fed minutes dating back to 1918. This is the type of rigor that Kathy Jones brings to her job, which is why her commentary is valuable, at a time when bondholders must be concerned about preservation of capital and outflows from the bond market.

Read Kathy Jones' ongoing bond market commentary on Schwab.com.

Natalie Pace: We've all been hearing about the Bond Exodus. Is this really an exodus. Or is this just press hyperbole?

Kathy Jones: There's a fair amount of hyperbole, however there certainly has been an outflow of bond funds, primarily muni bond funds and long-term bond funds. I wouldn't call it a mass exodus.

Where's the money going?

Into shorter bond funds or into bank loan funds, floating funds, or into cash. We're calling it Duration Rotation. People are taking money off of the Long Duration table and putting it on the Short Duration table.

Detroit forces us to look at muni bonds with a much sharper focus. What's your take on the muni bond market? So many people have purchased muni bonds for the triple tax free status, without ever considering that they might lose some of their principle.

We generally think the muni bond market, from a credit perspective, particularly revenue-backed bonds, are fine for most people - in the investment grade. We're going to have some credit events like Detroit and Stockton, California, like Harrisburg, Pennsylvania, as a result of the legacy issues that are going on. There will be some interest rate risk.

Detroit may have seemed fine 13 years ago when bondholders were buying. Can a credit rating really protect you?

Keep in mind that Detroit has been a high yield issuer for years now, and Detroit's problems have been coming on for decades. It's highly unlikely that if you are an investor you didn't know Detroit had some problems.

Is there a revenue bond that you like more than others? Muriel Siebert (RIP) was fond of water revenue bonds. On the other hand, some nuclear power plant revenue bonds have been meltdowns.

Sewer and water are the classic revenue bonds that people go to because generally speaking people need water and sewage systems. Parking revenue bonds might be a little riskier than water revenue bonds. You clearly have to know what you are doing. Or buy a fund where you have confidence in the fund manager, or have someone managing it for you.

You were drawing parallels between our economy today and post-World War II. What lessons can be drawn from that comparison?

I drew the parallel between the 40s and the 50s because it's the only time in history, that I could find, when the Fed had expanded its balance sheet to such an extent, and was basically using a lot of tools to try to cap interest rates at the same time. The parallel is that the ratio of Fed holdings to GDP was about where it is today. We'd gone from about 4 percent up to about 20+ percent, just as we've done over the last couple of years. The purpose was to hold down rates to finance the war debt. We had a big run-up in debt relative to GDP, and they were concerned that if interest rates went up that would be very costly to the treasury to finance the debt. I don't know if that is the main motivating factor for the Fed now, but it clearly is a risk as well. What was interesting was that when they finally came to an agreement between the Fed and Treasury to stop capping long-term rates and to allow the Fed to raise rates in 1951, rates didn't really go up very much.

Hmmm. What caused the rates to stagnate, instead of escalating?

There was this tremendous concern that inflation was going to get out of control and people were going to abandon the bond market, such as it is today. And it didn't happen because they raised rates a little bit and the economy sank into a shallow recession and rates actually came down. So even though short-term rates had gone up to about 1.5%, it took 18 years from the low for long-term rates to go back to where they were before this maneuver.

Well, you can certainly see how that is possible today. It just happened in Europe!

So, history doesn't repeat. And I'm not promising that it will be 18 years from the low back to 5%. We've been through a period, the worst period in terms of the economy, since the 30s. And, we're doing many of the same things that we did in the 40s. It strikes me that people are trying to equate this cycle with more normal cyclical behavior, rather than unusual economic circumstances.

In that scenario, if you have credit-worthy short and medium term bonds, you should be just fine, right?

Yes.

What about long-term bonds, if we end up with a 1950's type scenario?

We just don't think the risk-reward in longer-term bonds is that attractive. We prefer people, depending upon their portfolio, to stay a little bit more in the short term or medium term. Because it does seem that rates are going up to some extent.

Are there bond funds that are trying to position themselves as "better," which might be riskier than investors know?

There are a couple of crazes. Anything "floating rate" seems very popular right now, and "unconstrained," where the manager can go anywhere and do anything. The problem is that you don't really know where you are invested then. One of our tenets is, "Know what you own." Know what kind of bond fund you own. Know what it owns. Understand what the strategies are. How much leeway does the manager have? For example, we've been warning about the problems in Puerto Rico and their municipal bond market and how risky it is for a while now. They are at risk of a downgrade, perhaps below investment grade. What people weren't aware of, until [a recent] Barron's article, is that many bond funds own Puerto Rican bonds. They do this because the yields are so attractive. You could own a state of Maryland muni bond fund that actually has a high allocation to Puerto Rican bonds. That's the kind of thing we think investors should know about. Go on the website. Pull up their Top 10 Holdings. You can do that on Schwab.com. You can do that on the Internet. Go to the provider's website and see what they own. And make sure that is something that you are comfortable with.

Financial literacy is very important. But, people might be thinking, "How would I ever know that Puerto Rico is a "no," and Maryland is a "yes?" How would I know that Texas or North Dakota is better than Detroit? As I start on this journey of knowing more, where do I get the good information? There is so much noise out there. Whom do I trust?

There's more good information out there than people realize. Schwab publishes a lot of information. FINRA has a tremendous amount of information that is completely unbiased because it is coming from the regulatory authority. The MSRB also publishes information. If you want to educate yourself, you can.

Particularly if you are relying on your bonds for your monthly food and housing...

The bigger percentage of your portfolio, the more you rely on this for income, the more you should participate in the process.

Capital preservation is important!

There are Treasury bonds. I know everyone loves to hate the Treasury market, but there are Treasury bonds that can help you with that.

People are turning on financial news 24/7. Or they are scouring the Internet, and they just don't know which "expert" to believe. There are literally opinions across the board. And someone who works for I Just Started My Fund Yesterday dot com can be offering her "expert" opinions, too.

It is hard to parse through. I often tell people to turn off the TV. To some extent, a lot of the people who get on television are there because they have extreme points of view. And they are selling something. So, you don't want to just make a decision based upon just one person who has a face on television, or on the Internet, is telling you. You wouldn't buy a house that way. You wouldn't buy a car that way. And you shouldn't buy bonds that way.

About Kathy Jones
Kathy Jones is Vice President, Fixed Income Strategist, Schwab Center for Financial Research. Kathy Jones is responsible for credit-market and interest-rate analysis, as well as fixed income education for investors at Schwab. Jones has studied global credit markets extensively throughout her career as a fixed income investment strategist, working with both institutional and retail clients.