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Rate Hike Fears Spark 2015's Biggest Bond Fund Outflow

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According to the latest data from the Investment Company Institute, U.S.-based bond funds witnessed the biggest outflows in 2015. The year’s biggest outflow was attributed to the increasing fears about the possibility of the first rate hike in September. For the week ending Jul 29, $4.7 billion was pulled out of the US bond funds. This was the biggest weekly outflow since mid December and also reversed the $1.6 billion of inflows in the prior week.

Certain dismal economic data, such as the decline in ISM manufacturing index and weak wage growth data, have negated the Fed rate hike possibilities momentarily. Nonetheless, the balance towards the possibilities of rate hike is stronger, which is further evident from the bond fund outflows.

The primary forms of bond risk include default risk and the interest rate risk. A low interest rate environment is favorable for investments in bond funds. This stems from the fact that the market value of a bond is inversely proportional to interest rates. Government bond prices usually move up when yields drop along with lower interest rates.

Outcome of Latest FOMC Meeting

The Federal Open Market Committee’s two-day policy meeting gave no clear indication on the timing of the first rate hike. However, the door for a September rate hike was kept open.

The policy makers said: “The labor market continued to improve, with solid job gains and declining unemployment”. The committee also said that “economic activity has been expanding moderately in recent months” and that there has been “moderate” improvement in consumer spending levels along with an “additional improvement” in the housing market.

These comments did raise speculations of a possible rate hike in September or at the most in December. However, the committee also mentioned “inflation continued to run below the Committee's longer-run objective.” The central bank’s inflation target is 2%.the Fed remained dovish about economic health, which increased September rate hike possibilities. The Federal Reserve Chairwoman Janet Yellen stated that the U.S. economy will strengthen and expects the central bank to hike interest rates “at some point this year.”

Fed Officials Signal Hike in September

In an interview with The Wall Street Journal, Atlanta Fed Reserve president Dennis Lockhart signaled that the Fed is preparing for a rate hike in September. He said that the given economic scenario is “appropriate” to opt for a rate hike in near future unless the economy witnesses a "significant deterioration". He stated: "I think there is a high bar right now to not acting, speaking for myself… My priors going into the (September) meeting as of today are that the economy is ready and it is an appropriate time to make a change."

Last month, San Francisco Fed President John Williams said that a rate hike could take place as soon as September. Williams believes that inflation will soon increase to the Fed’s target rate of 2%. There was a high probability that it could go even higher by the end of next year.

Williams added that full employment could be achieved even before the end of 2016. His views are of particular significance since he is a voting member of the Fed’s decision-making body. Additionally, he takes a moderate stance on such issues, consistent with the position of the current Fed Chair.

Previously, New York Fed President William Dudley had said a rate hike would be “very much in play” during the Fed’s September meeting. Dudley added that this was, of course, associated with continuing evidence that the economy was continuing to recover.

International Bond Funds as Alternative?

As the Fed hikes interest rates, a sell-off in bond funds is likely to take place as investors switch to safer choices. Some experts have even suggested that investors should move out of such securities as soon as the rate hike takes place. The influential Carl Icahn also expressed similar views. He said the junk bond market was “extremely overheated.”

However, for investors interested in the space, there are actually some alternatives they can try. International Bond funds are great alternatives, as they are one of the best ways to balance losses incurred from US markets, since interest rate fluctuations differ from country to country.

Considered to be among the world’s largest asset classes, International Bond funds show little correlation with domestic equities and only moderate correlation with investment grade domestic debt. They also help in diversifying currency exposure and protecting assets against a long-term secular decline in the U.S. dollar.

Below we present 3 International Bond – Developed mutual funds that carry either a Zacks Mutual Fund Rank #1 (Strong Buy) and Zacks Mutual Fund Rank #2 (Buy).

Goldman Sachs High Yield Floating Rate A (GFRAX - Free Report) seeks high current income. GFRAX invests a lion’s share of its assets in domestic or foreign floating rate loans and other floating or variable rate obligations that are rated below investment grade. GFRAX may invest a maximum of 20% of its assets in fixed income instruments regardless of their ratings. These may comprise fixed rate corporate bonds, government bonds and convertible debt obligations among others.

GFRAX currently carries a Zacks Mutual Fund Rank #1 (Strong Buy). The year-to-date and 1-year returns are 1.9% and 1.7%. The 3-year annualized return is 3.2%. The expense ratio of 0.94% is lower than the category average of 1.11%.

Payden Global Fixed Income (PYGFX - Free Report) invests in varied debt instruments and income-producing securities. A minimum of 65% of assets is invested in investment grade debt securities. A maximum of 35% of assets may be invested in junk bonds. However, the overall average credit quality of the fund will be investment grade.

PYGFX currently carries a Zacks Mutual Fund Rank #1 (Strong Buy). The year-to-date and 1-year returns are 1.5% and 3.9%. The 3-year and 5-year annualized returns are 3.6% and 4%. The expense ratio of 0.7% is lower than the category average of 1.03%.

Eaton Vance Global Macro Absolute Return A (EAGMX - Free Report) invests in securities and derivatives among other instruments to gain short and long investment exposures across the globe. The short and long investments are sovereign exposures, which include currencies, interest rates and debt instruments. EAGMX invests in many countries and has significant exposure to foreign currencies.

EAGMX currently carries a Zacks Mutual Fund Rank #1 (Strong Buy). The year-to-date and 1-year returns are 1.7% and 3.1%. The 3-year annualized return is 1.8%. The expense ratio of 1.05% is lower than the category average of 1.28%.

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