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Fixed-Income Insights

Are investors fleeing fixed-income markets en masse for equities? Not quite. Here’s a closer look at the recent market action, and what it means for investors.

"The Great Rotation" has become the popular term for the notion that financial markets will experience a long-anticipated reversal of the massive investment flows of the past several years—flows that favored the fixed-income market. According to Investment Company Institute data, more than $300 billion flowed out of equity mutual funds during 2011 and 2012. An even larger amount flowed into fixed-income funds during that time.

But as the saying goes, "what goes around comes around." At some point, according to the proponents of the Great Rotation hypothesis, it should become obvious to investors that fixed income would become so overvalued as to place the fixed-income market firmly in "bubble" territory. And we know what happens to bubbles. In this case, the "Rotationists" believe, economic strength would turn investor sentiment against overvalued bonds via the twin fears of a rise in inflation and a Federal Reserve policy reversal toward higher interest rates. (Excessive money creation through the Fed's quantitative easing [QE] program was also meant to act as a catalyst for inflation.) At the same time, a more robust economy would translate into stronger growth in corporate earnings, making equities substantially more attractive than debt.

That's when the wheel would begin to turn, according to the proposition. Investors would flee debt securities, driving prices down. Equities would be the beneficiaries as investors realized bonds, long viewed as "safe haven" investments, could bear negative returns as rates rose and prices fell. Falling bond prices and rising equity prices would reinforce and exacerbate the reversal of investment flows of the past several years. And the so-called Great Rotation would neatly explain everything.

Going with the Flows
But would it really? To be sure, in 2013 equities have continued to climb while bonds have fallen in price, but the market action has not strictly followed the Great Rotation playbook. The differences are easy to overlook, but the investment consequences are important.

Equity prices showed improvement—as did the substantial inflows into equity funds—from the beginning of 2013. Year to date through July 12, the S&P 500 Index had risen 17%. Net inflows into equity mutual funds totaled nearly $63 billion in the first five months of the year, according to Investment Company Institute data. But the potential source of those funds might have been a surprise to the Rotationists: flows into equities appear not to have come out of bonds but rather represented an allocation from money market funds and deposits. According to ICI data, bond funds during the first five months of 2013 continued to attract even more flows than stocks, and at a pace consistent with 2011 and 2012. Meanwhile, money market funds resumed their multiyear outflow trend.

The move to equities was supported not by stronger economic growth expected by Rotationists but by persistent profit growth in a slowly improving economy. Income in the S&P 500 advanced an average of 4.3% in each of the last five quarters, according to Bloomberg data.1 Investors also may have been impressed by the resilience of the U.S. economy, and corporate earnings, in the face of some formidable challenges: the much-feared "fiscal cliff," the expected dampening effect on the economy of higher income taxes and a reinstatement of the payroll tax, and reduced government spending from the budget sequester.

If consensus economic expectations are any kind of guide, the move toward stocks was not in response to a shift toward expectations of stronger annual economic growth of 3% or more but a realization that the current backdrop—gross domestic product growth at a more modest 2% and potentially fewer downside risks attributable to the economic challenges mentioned earlier—created a relative opportunity in equities that was compelling enough to invest cash reserves. Indeed, if investors were on the cusp of higher growth expectations, the Fed's signals that stronger growth in the second half of 2013 would allow the central bank to begin reducing the amount of monetary stimulus (a policy move popularly known as "tapering") would likely have had  an immediate positive impact on equities, rather than the sell-off that ensued.

Fretting about the Federal Reserve
It was precisely the fear of tapering that caused selling among bond funds. Again, this was not the Great Rotation; investors sold both stock and bond funds in June. Fixed-income investors seemed to panic at the thought of losing one of their biggest buyers, the Fed. Illogically, all categories of fixed income endured sell-offs, producing, at least initially, even larger price declines in less liquid markets, such as high-yield and municipals, than in markets like Treasuries that would be directly affected by Fed tapering, if indeed the policy does unfold on the preferred timetable expressed by Fed chairman Ben Bernanke on June 19.2

While on the surface investor flight from all aspects of fixed income may be consistent with the Great Rotation, two of the underlying factors often mentioned as bond-market bête noirs—rising inflation and unfavorable relative value measures—don't hold up under closer inspection. Under the Great Rotation, higher inflation, courtesy of excessive monetary accommodation, was intended to support the shift from bonds to stocks. As recent declines in the market for Treasury Inflation-Protected Securities (TIPS) will attest, inflation is far from the envisioned catalyst that would spark this shift. Indeed, recent data releases from the Bureau of Labor Statistics show the broad Consumer Price Index holding well below 2% on an annualized basis.

Second, particular segments of the bond market, such as lower-quality corporate bonds and municipals, continue to display favorable value relative to Treasuries. Not only are yield spreads close to historical averages or wider but compared to reasonable earnings growth expectations they also seem attractive relative to equities.

If, for example, corporate profit margins do not change from current levels, earnings growth will likely adhere to the following formula:


 
How 2% GDP Growth Could Result in 6–8% Earnings Growth

Source: Lord Abbett. These values are estimates to illustrate possible aggregate earnings growth for the S&P 500 Index.

 

If investors value those earnings at today's price-to-earnings (P/E) multiple, an annual return of 6–8% would not be unattractive in an environment of 2% growth.  And any increase from today's multiple would amplify that return.

At the same time, high-yield securities at yields of around 6.5% (as represented by the BofA Merrill Lynch High Yield Master II Constrained Index) look relatively attractive, especially in an environment of historically low defaults. Similarly, bank loans offer a yield of about 4.9% (as represented by the Credit Suisse Leveraged Loan Index).  Higher marginal tax brackets continue to favor municipal bonds, especially when 'A' rated bonds (as represented by the BofA Merrill Lynch Single A Municipal Securities Index) and 'BBB' rated bonds (as represented by the BofA Merrill Lynch BBB Municipal Securities Index) offer pretax equivalent yields of 5.6% and 7.4%, respectively, based on a 35% tax bracket (5.1% and 6.7%, respectively, based on a 28% tax bracket). Tax-equivalent yield does not take into account state and local taxes or the alternative minimum tax, if any, and will vary based on an investor's tax bracket.  (Yield data from Bloomberg.)

The Next Rotation?
Granted, continued investor interest in equities could indeed increase their prices far more via expanded P/E multiples than the 6–8% earnings growth previously constructed, and security selection will likely be important in such an environment. At the same time, asset classes that are considered safe havens—Treasuries, agencies, and high-quality corporates—are likely to bear the brunt of investor concern regarding a gradual unwinding of the Fed's QE policy.

It seems, however, that once investors realize the consequences of eventual tapering by the Fed, 2% growth, low inflation, and current relative value, credit rotation may better describe upcoming flows, or investor strategy. Namely, investors may decide to move out of perceived high-quality safe havens, especially issues with longer duration, and into credit-sensitive instruments, such as the lower tiers of investment-grade securities, high-yield, and equities. That could be the turn of events that redefines the Great Rotation.

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