Well the bond bears, most of who have been bearish on bonds for the past 3-4 years ("rates have nowhere to go but up") are now out in full force.
On this topic, the first thing we need to do when we are talking about "bonds" is differentiate between all the different sub-asset classes of bonds that exist. Perhaps the best way to do so is to compare the various bond sub-asset classes and their different forms of risk through correlation studies:
1. Government of Canada (or US Treasury) Bonds: These are pure interest rate risk...100% interest rate risk. When we talk broadly about "bonds" this is what most people are talking about.
2. Provincial (Munis etc) Bonds: These are about 90% interest rate risk and about 10% credit risk. IE, Provincial bonds will trade pretty much like Government of Canada bonds. Not a ton of difference between the annual returns of the Prov of Alta bonds and the Prov of Sask bonds.
3. Investment Grade Bonds: IG or corporate bonds correlate at about 45% to Govt of Cda bonds so they are about 45% interest rate risk and about 55% credit risk. If rates (Govt of Cda bonds) move higher, corporate bonds will feel the effect, to be sure.
4. High Yield Bonds: Interestingly, HY have 0% correlation to interest rates! That is to say, they are 0% interest rate risk and 100% credit risk. Why is that? Well if central bankers start talking or moving rates higher, why are they doing so? Probably because the economy is finally improving and the need to get ahead of the curve on inflation. Well if the economy is improving then that means companies have more cash flow. And what does that cash flow do for us HY bond holders? It pays our coupon! And if we have more cash flow in that company to pay our coupon (called, "interest coverage") then we are in a stronger position. Therefore, higher rates are a good thing for HY bonds! (Unless rates are higher due to a fiscal crisis, then all bets are off).
Now that we have that sorted out, we can address this Great Rotation out of "bonds" and into equities. My former colleagues at BAML have been strong proponents of this theory. About 3 weeks ago, I was at a BAML lunch where the global credit strategist was going on and on about this rotation. Back to our explanation above, which bonds is it that investors are going to dump in favour of equities? He claimed that investors would likely dump out of Govt debt and corporate (IG) bonds in favour of equities. Respectfully, I engaged him on a few counter points:
1. I don't disagree with some movement out of Govt and corporate debt in favour of equities but the over-riding factor would be something we have been talking about as the one known and one constant in the market that has far-reaching themes, like investor preference for asset classes; The Aging Demographic. As the baby boomers hit 65yrs old, there will be a constant demand for fixed income investments, in general, and that is a theme that will last the next 30yrs.
2. To be sure, 10yr Cda and US Treasury bonds at 1.50% may not be good value but at 2+% there is a case to be made where very large pension funds, with out of control pension deficits, favour 10yr Govt bonds at 2+% vs stocks at all-time highs.
3. Flow of Funds is very important. In the USA, so far in 2013, we have seen mutual fund inflows into equity funds at about $44bln and inflows into bond funds at 38bln. Both inflows...interesting...doesn't sound like a great rotation out of bonds and into stocks as of yet, anyway. And where did the money flow out of? Money Market Funds. Makes sense.
4. One other factor in favour of bonds right now is that US Primary Treasury Bond Dealers are the most short treasury bonds they have been since before the '08 crisis. What do you think the "path to pain" is; higher rates? Not likely. When everyone is lined up/loaded up the same way, the most-expected outcome rarely happens. Quite frankly, it can't happen.
And what about HY bonds specifically? Well our view is that the economy is in ok shape trying to emerge from a terrible accident 4yrs ago and is limping off the mat. There are signs of improvement (US housing) while there are still signs of trouble (the US political situation, most notably the deficit). HY issuers are still in very good shape with high cash balances, average leverage and above average interest coverage (see above), along with termed out bank debt and bond debt which creates a longer runway for these issuers as it removes refinance risk. Very good macro credit fundamentals are still in place. Is HY overdone? Well, to be sure, last year was a good year but we have a backdrop of strong credit fundamentals, a demographic need for "true yield" based on an indenture, not volatile equity-based dividend yield, and then all those other positive fundamentals that favour HY over stocks over most holding period returns...and certainly on a risk-adjusted basis. We do not think HY will weaken off at all while equities run up. It is most likely that HY will be stuck in a holding pattern that could see US HY spreads between 450 and 650bps (currently 496bps) for the next couple of years (matches the Fed's outlook on rates). This is what we would call "A good coupon year". Nothing wrong with a 7-9% return this year with significantly reduced volatility in HY vs stocks (HY is usually about half as volatile as stocks over holding periods of 5yrs or more).
Bottom line - If there is weakness in the HY markets right now, it will be due to an exogenous shock and the demographic will support the market at the new lower prices. Again, this demographic theme is extremely important, powerful and long-lasting.