While many investors remain like deer in headlights amid ongoing bond market uncertainty, others are bounding in various directions both inside and outside fixed income.

Investors yanked a record $70.7 billion from U.S. bond mutual funds last year through the first week of December, according to TrimTabs Investment Research. They also continue to swap out traditional core fixed-income products for other bond options offering lower interest rate sensitivity and higher yield. However, in the week ended January 8, inflows into bond funds marked the biggest cash surge since May, and may signal a reversal in the sentiment toward bonds, Reuters reported.

Significant estimated net outflows last year from intermediate-term bond funds ($78.89 billion) and intermediate government funds ($34.41 billion) were coupled with hefty inflows to bank-loan funds ($61.33 billion) and nontraditional bond funds ($55.03 billion), according to Morningstar.

“You read a lot in the press about rising interest rates,” says Sarah Bush, a senior analyst with Morningstar and co-head of fixed income on its active funds research team. “I can’t get in the average investor’s head, but watching these flows, that does seem to be driving a lot of behavior.”

What concerns Bush and fixed-income specialists is that retail investors may unknowingly swap out interest-rate risk for credit risk in asset classes such as bank loans and nontraditional bonds, which both invest in below-investment-grade debt. Furthermore, bank loans are “an asset class without a ton of upside,” she says, since it generally trades close to par. Therefore, getting out after a decline “would be pretty much a permanent capital loss,” she says.

Investors also remain a little uneasy about tapering of bond buying by the Federal Reserve, the mere mention of which sent the fixed-income market into a tailspin last spring. Although the Fed is proceeding slowly and expects to keep short-term interest rates very low until the unemployment rate drops, many macroeconomic unknowns persist and longer-term rates are expected to move higher.

 “It’s another tough year for traditional fixed income,” says Jeffrey Rosenberg, chief investment strategist for fixed income at BlackRock, Inc. The world’s largest asset manager had $1.3 trillion in fixed-income assets under management as of September 30, its most recent available data. BlackRock forecasts a 50 basis point rise for the 10-year Treasury yield this year. “That’s enough to basically render traditional fixed income returns around zero for 2014,” he says.

Investors in search of better returns have been “potentially jumping out of the frying pan and into the fire,” he says, by latching onto fixed-income securities with two- to five-year maturities in such popular asset classes as short duration and bank loans. However, “recent data suggests the economy in 2014 might just surprise and deliver,” he says, “and in that kind of environment, this part of the yield curve is most vulnerable.” He says rates on such investments could rise much more than 50 basis points.

To generate positive returns, BlackRock is investing more in longer-duration Treasurys, municipal bonds and Treasury Inflation Protected Securities (TIPS) while establishing short positions in the shorter and less interest rate-sensitive parts of the yield curve.

BlackRock is reducing its credit risk by underweighting bank loans and corporate bonds and being more cautious with its still-overweight position in the high-yield asset class, says Rosenberg. It is also overweight dollar sovereign debt in emerging markets.  

So what lies ahead in fixed income and how are portfolio managers trying to manage their expectations and the potential risks?

“We believe that 2013 is a good preview of what we’ll see in 2014,” says Mark Okada, co-founder and chief investment officer of Highland Capital Management, a Dallas-based investment advisor with $18 billion of assets under management. “There are going to be some bouts of volatility like we saw in the taper tantrum.”

During this 2013 event, the yield on 10-year Treasurys rose 100 basis points in one month with really no fundamental changes other than the Fed talking about the possibility of reducing its bond purchases, says Okada, who manages the Highland Floating Rate Opportunities Fund, a bank-loan fund with $1.4 billion of assets. According to Morningstar, its institutional Z-share class posted a 17.35% return in 2013 (Okada notes it did not use its leverage facility) and ranked in the top percentile in performance among U.S. open-ended bank loan funds.

Continued economic recovery, great in some areas and more challenged in others, “is going to be the primary driver of the rise in rates,” says Okada. Highland expects the 10-year Treasury yield to be around 3.5% at year-end. Based on the Fed’s forward guidance, we won’t see the front end of the yield curve move until 2015, he says.

Still, he is concerned that short-term liquidity flows could overwhelm the rate market like during the taper tantrum. The Fed’s monetary policy has forced a lot of liquidity into the system, which has been pushed into the hands of a more concentrated group of investors as banks and mutual fund houses have recently gotten much bigger, he says.

Should there be a very positive economic backdrop this year, “you could see pretty significant liquidity drain on the Treasury market,” he adds, “and we would think that certainly could cause rates to spike.” Meanwhile, he says it’s going to be challenging for the equity market to continue to rise because its overall valuation is stretched.

The Highland Floating Rate Opportunities Fund has 75% of its assets in bank loans, which are floating-rate debt. It is getting this exposure through large capitalization issuers, not middle-market issuers. Okada notes that other people are stretching for yield by moving down in credit quality and size. “We just think it’s a real mistake,” he says. “Over the next couple of years, most of the distress in this space is going to come from this activity, so we’re avoiding it completely.”

The large-cap loans, unlike middle-market loans, offer secondary market liquidity, which enables the fund to get out of them if Highland’s research says it should, he says.

Collateralized loan obligations (CLOs)—securities based on loans pooled together in a structure—and restructuring assets have also been strong contributors to the fund’s performance, he says. Highland helped turn around the businesses of its issuers that went through bankruptcy after the financial crisis and their debt was converted to equity. The fund is now exiting those equities through merger, acquisition and IPO events and rolling those gains back into bank loans.

Aaron Izenstark, co-founder and chief investment officer of IRON Financial LLC, a Northbrook, Ill.-based firm that manages approximately $2.1 billion in assets, expects to see a slow rise in interest rates, especially on the intermediate-to-long end of the yield curve.

“You have essentially a trillion-dollar buyer in the marketplace that is going to taper or disappear altogether, and that’s going to bring collateral damage to many pieces of the fixed-income market,” he says. “It’s going to suppress yields and put the supply-demand issue out of balance.”

Additionally, large quantities of low-quality debt are being issued now and the market could become very illiquid if there is a credit event, he says.

Izenstark co-manages the IRON Strategic Income Fund, a credit opportunity fund that in 2013, according to Morningstar, posted a 6.32% return for its institutional shares and ranked in the top 1% in performance among U.S. open-ended nontraditional bond funds. The fund typically keeps duration at two to three years to reduce interest-rate sensitivity. It hedges interest-rate risk by using Treasury futures and hedges credit risk by using the North American High Yield Credit Default Swap Index (CDX).

Around 85% of the fund’s approximately $450 million in assets are allocated to corporate bonds, most of which are below investment grade. It has a 6% position in convertible securities, which has let it take advantage of rising stock prices. IRON Financial performs deep credit work to find overlooked, non-rated convertible securities, he says.

Izenstark expects alternatives to play an increasing role in fixed income but cautions investors to do their homework. While funds that use these strategies are lumped together in Morningstar’s nontraditional bond category, he says, “everyone is doing something different.”

Bruce Mandel, president and CEO of Oakwood Capital Management LLC, a Los Angeles-based firm with assets approaching $700 million, also anticipates a slow rise in interest rates. “We believe it’s really a multiyear plan driven by economic circumstances,” he says. “We’re going to get the pops like we did in May and June, and then kind of a settling back to reality.”

The largest allocation in Oakwood’s core taxable fixed-income strategies is corporate bonds (65% to 75%). Floating-rate securities (corporate and agency type) and federal agency callable securities each account for 10% to 15%, followed by cash (5% to 10%). In sharp contrast, U.S. Treasury positions averaged 50% to 60% of its total portfolio holdings three years ago.

Oakwood is also looking to the stock market for guidance. If stocks experience significant weakness, it is likely to reduce its credit-quality-sensitive corporate bond positions in favor of price-sensitive U.S. Treasury securities, says Mandel. If stock prices move higher, it will maintain credit- and yield-sensitive corporate bonds. “Significant stock market weakness may prompt lengthening in portfolio durations, while a rally may prompt shortening,” he adds.

Oakwood mostly uses individual fixed-income securities, which Mandel says offer better pricing control. It also uses some institutional bond funds from Dimensional Fund Advisors, but is avoiding retail-traded funds because of their huge redemption activity. “What they’re having to liquidate, sadly, are shortest maturities and highest qualities,” he says, “and thus people who are left within the fund are seeing price erosion and increasing risk in the structure of the funds.”

Waiting Patiently
Francis Chou, CEO of Toronto-based Chou Associates Management Inc. and Chou America Management Inc. (combined AUM: $875 million) continues to maintain a large position in cash and cash equivalents in the Chou Income Fund, a U.S.-based world bond fund he manages. U.S. Treasury bills made up 49.4% of the fund’s total holdings as of September 30, when the most recent data was published.

But fear of tapering and rising rates aren’t driving this decision. “We’re somewhat agnostic to what the Fed is doing,” he says. “We just can’t find anything to buy.”

“Non-investment-grade debt securities are fully priced and in general, I would stay clear of them,” Chou wrote in his 2013 semiannual report to holders of the Chou Bond Fund, a Canadian mutual fund he manages. Some of these securities may be overvalued, their prices don’t reflect their inherent risks and the possibility of large, permanent loss of capital is high, he says.

Sitting in Treasury bills enables the Chou Income Fund to preserve capital while awaiting more favorable market conditions, says Chou. Should interest rates rise, it won’t impact these holdings because their maturities are so short.

According to Morningstar, the fund posted a 2013 return of 22.86% and ranked in the top percentile in performance among U.S. open-ended world bond funds. Concentration in a few undervalued debt securities, including a term loan from R.H. Donnelley Inc., enhanced its return, says Chou. The directories publisher, which emerged from bankruptcy and is now part of holding company Dex One Corp., made up 11.2% of the fund’s assets as of September 30.

Izenstark sums up the general mood in fixed income: “You never get used to crazy markets because that’s what they are—crazy and unpredictable,” he says, “but you still need to make sure you have a process that doesn’t blow up.”