What’s a Poor Bond Manager To Do?

With the consensus wisdom now pervasive that the 60 year bull market in bonds is over, what is a poor bond fund manager to do? Has he now become the defacto manager of the New York Mets, condemned to reliably losing every season? Pity the hapless financial advisor who has to drag clients, kicking and screaming, out of what has worked so well for the last several decades.

Those who earn their daily crust of bread from the fixed income markets could well be facing a perfect storm in 2013. The headline risk from Europe could vanish, US GDP growth accelerates, and the housing and auto markets continue robust recoveries. A speed up in China’s business activity would be the final nail in the coffin.

What’s more, the action of the Fed could turn the modest weakness we have seen so far into an absolute rout. If they ease too soon, the best bond managers may be able to trade around the gradual rise in interest rates that results.

If the Fed eases too late, real inflation will return, and the risk of a real bond crash presents its ugly face. What is most concerning is that no less a figure than Ben Bernanke himself has said the challenge of getting it right is on the scale of finding a needle in a haystack.

The price for getting it wrong is large. Jack up the yield on ten year Treasuries (TLT) from today’s 2.0% to 4.5%, which some traders believe could happen by the end of this year, and your bond principal plunges by 23%. Here’s a prediction for you: I expect a sudden upsurge in the demand for coronary specialist to skyrocket, as many bond investors suffer heart attacks when they open their yearend statements.

We all could suffer heart failure if conditions in the bond markets get too dire. Drop the value of everyone’s largest holding too quickly, and it could trigger another financial crisis, one that makes 2008 look like a cakewalk. Be careful what you wish for.

There are a few great managers out there who will be able to make money in the bear market. For a start, you de-risk, dumping long dated Treasuries and municipal bonds and anything else with a fig leaf of a low coupon. Shorten duration wherever you can.

A big premium will be paid for bond managers who can be creative and imaginative in squiring their investments. These are the sharp guys who are moving into floating rate loans and high yielding direct bank loans. Their Spanish and Portuguese language lessons are paying off, with cash getting funneled into foreign debt markets that don’t track with the US yield curve. These guys will also get a nice foreign currency kicker in a weak dollar universe.

It might also require managers to expand the definition of the term “bond” to stay in the black. You saw the equity guys engage in this sort of “mission creep” when bonds were hot. This might include investing in convertible bonds (CWB) and other various hybrid securities. Investing in the debt of sector winners, like financials and energy, will be a winner. My own favorite in this field are ultra high yield REIT’s (NLY) and Master Limited Partnerships (CVRR).

It’s clear that the salad days are over for bond managers. They are really going to have to pedal hard from here on just to break even. Most will lose money no matter what they do.

Individual investors can give themselves some edge by moving money away from large managers that will suffer the most from shrinking liquidity, and towards smaller, more nimble ones who can dance between the raindrops. Target those with less than $10 billion in assets who can take advantage of smaller, high yielding deals.

Want to try something really gutsy and against the grain? Switch out of California state tax free debt, which has just enjoyed a massive rally thanks to governor Jerry Brown’s budget balancing efforts, into Illinois debt, now the lowest rated in the nation. Neither state is likely to default, and you pick up 80 basis points in yield on the switch. Click here to read “The Muni Bond Myth” for the reasons why.

TLT 2-15-13

CWB 2-15-13

NLY 2-15-13

Man-Chestpain

But My Financial Advisor Told Me Bonds Were Safe