A Fed rate hike will probably not occur before June. This is being judged by the latest batch of mixed economic reports and the FOMC minutes. While that reduces the interest rate risk associated with bonds, another risk factor has emerged to be a top agenda for many fund managers. This is the bond liquidity risk. A rise in rates may lead to bond exodus; when the lack of liquidity may compel investors to sell the asset class at significant discount.
The sharp sell-off in bonds earlier this month highlighted this risk. Increase in bond yields dragged bond prices down. On May 12th the U.S. 10-year Treasury yields touched its highest level since Nov 21st of last year. This was a result of improving European economy, reduced deflationary concerns and rate hike expectations.
Assets are deemed liquid when an investor can buy or sell large quantities rapidly at an expected price. For bonds, the sovereign government bonds are said to be the most liquid. However, corporate bonds may suffer. A Financial Times article notes that the head of the trade body for UK asset managers believe that liquidity problems are the biggest threat to bond funds.
The article states: “Government bond yields, which move inversely with prices, have risen over the past two months amid a spike in volatility; this has also weighed on corporate bond markets and brought fears over liquidity levels back into the spotlight”.
Concerns about Bond Sell-Off
There is a growing concern that a massive exit from bonds may freeze the markets as the number of sellers may not match the number of buyers. An ideal market would be the presence of right level of liquidity at the right price. This should keep the financial system running and also help monetary policies.
Redemption of bonds would increase the sell off and then fund managers will have to sell the less liquid assets to match the investors’ cash demands. However if a mutual fund or an ETF holds illiquid bonds, the price swings will be rapid and would create a vicious cycle as price drops will again intensify selling pressure.
In the post financial crisis era, new regulations and capital requirements has compelled Wall Street banks to cut their inventories. This has made the buy and sell activity of corporate bonds in the secondary market more difficult. The drop in inventories following the regulations has created a gap in the number of buyers and sellers. Thus, bond fund managers are now less prone to holding a large chunk of bonds in fear of any possible rout.
No Need to Panic?
On the other hand, a Forbes article cites the speculation of lack of liquidity as overblown. It says that there is no need to panic over speculations that the liquidity crunch will lead to fallout for bond ETFs while rates rise and investors exit this asset class.
Experts opined that the migration would be a gradual process instead of being a ‘rapid’ evacuation.
Stock Holdings to Provide Liquidity in Rout
During the debt market selloff, bond fund managers say that substantial stock holdings would provide the edge. Any possible turbulence in the bond market will be met with the selling of large stock positions. Proceeds from equities can be used to offset discounted bonds.
New asset allocation rules have helped multi-sector and junk bond funds in this regard, as the new provision allows them to include as much as 35% of stocks in their portfolios.
Matt Eagan, a portfolio manager of Loomis Sayles Strategic Income Fund (NEFZX - MF report), acknowledges the role of stocks as liquidity in the portfolio. Also, Eaton Vance Bond Fund’s manager Henry Peabody says: “If rates rise, we expect some displacement in the bond market…We'll look at unwinding some of that equity position to find some of the cheaper bond credits out there”.
3 Balanced Mutual Funds to Buy
Balanced funds provide investors with the convenience of buying into a single fund rather than holding both equity and bond funds. This category of funds also reduces a portfolio’s volatility while providing higher returns than pure fixed income investments. Fund managers of such funds also enjoy the flexibility of varying the proportion of equity and fixed income investments in response to market conditions. An upswing may prompt them to hold a relatively higher share of equity in order to maximize gains; whereas a downturn sees them turning to fixed income investments to stem losses.
Below we present 3 Balanced mutual funds that carry Zacks Mutual Fund Rank #1 (Strong Buy) as we expect the funds to outperform its peers in the future. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but the likely future success of the fund.
These funds carry no sales load, have a low expense ratio and the minimum initial investment is within $5000. The funds have total returns above 10% for each of the 1, 3 and 5-year periods. Their assets are allocated both in stocks and bonds.
PIMCO StocksPLUS D (PSPDX - MF report) seeks total return above the S&P 500 Index’s return by investing in S&P 500 Index derivatives and a portfolio of Fixed Income Instruments. These include bonds and debt securities among others, which are issued by various U.S. and non-U.S. public- or private-sector entities. A maximum of 30% may be invested in foreign currencies denominated securities, or may invest over 30% in U.S. dollar-denominated securities of foreign issuers.
PSPDX currently carries a Zacks Mutual Fund Rank #1 (Strong Buy) and has returned 15.7% over the past 1 year with 3 and 5-year annualized returns being 21.6% and 18.3%. PSPDX has an annual expense ratio of 0.9% as compared to category average of 1.05%. PIMCO StocksPLUS D has 37.91% of its assets invested in stocks and 29.74% in bonds.
Putnam Dynamic Asset Allocation Balanced Y (PABYX - MF report) seeks total return. The fund has a strategic allocation whereby PABYX may invest 45-75% of its assets in equity securities and 25-55% of its assets in fixed income securities. The percentage of the allocation of the assets is decided by the prevailing economic conditions.
PABYX currently carries a Zacks Mutual Fund Rank #1 (Strong Buy) and has returned 12% over the past 1 year with 3 and 5-year annualized returns being 14.9% and 12.6%. PABYX has an annual expense ratio of 0.74% as compared to category average of 0.91%. Putnam Dynamic Asset Allocation Balanced Y has 54.43% of its assets invested in stocks and 30.79% in bonds.
Fidelity Balanced (FBALX - MF report) invests around 60% of its assets in equity securities and the remainder in a balance of debt securities including bonds and lower-quality debt instruments. FBALX is expected to invest a minimum of one-fourth of its assets in fixed-income senior securities. FBALX invests in securities throughout the globe.
FBALX currently carries a Zacks Mutual Fund Rank #1 (Strong Buy) and has returned 12.7% over the past 1 year with 3 and 5-year annualized returns being 14.9% and 12.7%. FBALX has an annual expense ratio of 0.56% as compared to category average of 0.91%. Fidelity Balanced has 68.53% of its assets invested in stocks and 25.89% in bonds.
About Zacks Mutual Fund Rank
By applying the Zacks Rank to mutual funds, investors can find funds that not only outpaced the market in the past but are also expected to outperform going forward. Pick the best mutual funds with the Zacks Rank.