Taper decision may boost interest in fixed income

Money managers' response to the Federal Reserve's decision to cut its monthly bond purchases to $75 billion in January from $85 billion is much more optimistic than it was when the topic first was broached.

In fact, as a result of the Fed's decision last week, some expect to see an accelerated interest in fixed-income strategies next year.

“We're pleased with the Fed's decision, having long argued that the last round of quantitative easing was too large and disrupted the proper functioning of financial markets without meaningfully helping the labor market,” said Rick Rieder, chief investment officer of fixed income for BlackRockInc., New York, which manages $640 billion in fixed-income assets. “This is a step in the right direction.”

One of the main reasons for the industry's moderate reaction to the Fed's Dec. 18 announcement that it will in January start slimming its bond-buying is that it has been long anticipated. Investors and money managers have been expecting it since the discussion about so-called “tapering” began last May.

Mr. Rieder for one doesn't think the Fed's decision will be a “big shock” for bonds, since there's still plenty of “easy money” in the global financial system. “We're looking for the 10-year Treasury to inch up to 3.25% or so by the middle of next year. So-called spread sectors, (such as) high yield, commercial mortgages and other asset-backed bonds, are all still better bets than Treasuries,” said Mr. Rieder.

The yield on the 10-year bond rose two basis points to 2.89% late on Friday from 2.87% on Wednesday after the Fed's announcement.

“This is something that we've all been waiting for,” said Dave Breazzano, president of DDJ Capital Management LLC, Waltham, Mass. “People knew it was coming. It was just a question of when.” DDJ manages $7 billion in high-yield, bank loan and special situations investments.

Contrary to what many in the industry initially expected, there appears to be no “taper tantrums” now that the Fed has provided a start date and a target amount.

In fact, equity markets rallied upon the news. The Dow Jones industrial average rose 292.71 points, or 1.84%, on Dec. 18 after the Fed's announcement.

It appears the discussion about tapering wound up causing more volatility than the actual event.

“Market reaction is fairly muted,” said John Bellows, portfolio manager and research analyst with fixed-income manager Western Asset Management Co., Pasadena, Calif., which runs $443 billion. “Interest rates are up (slightly), but that's not a very big move in the context of what we saw in the summer, so that's encouraging for people looking at their bond portfolios.”

The 10-year Treasury rose about 95 basis points to 2.97% in September from 2.02% in late May.

Another reason money managers are rather sanguine about the Fed's latest news is, with equity markets up more than 20%, many of them are closing out the year enjoying strong returns on their overall portfolios.

“Interest rates are now slightly higher and equity markets are up,” said Douglas M. Hodge, chief operating officer and a managing director in Pacific Investment Management Co.'s Newport Beach, Calif. office. “So this relationship between cash and bonds and stocks is moving toward a more normalized relative value.”

PIMCO had $1.97 trillion under management as of Sept. 30, the vast majority in fixed income.

As a result, institutional investor appetite for alternative fixed-income strategies might increase at a rapid rate as a result of Fed tapering.

“If you look at the past year, you've seen flows shifting from the classic fixed-income products into these next-generation fixed-income products,” said Yariv Itah, a partner at consultant Casey, Quirk & Associates, Darien, Conn., citing such strategies as emerging market debt, loans and global bonds as part of that next generation. “We think this move is going to accelerate.”

Western Asset's Mr. Bellows also noted that once asset owners that were previously worried about tapering see there's no cause for alarm, he believes they will find fixed income overall more attractive.

“The big problem with fixed income was that yields were so low (investors) didn't make their return requirements. So if yields continue to move up, all of a sudden that dynamic starts to shift,” added DDJ's Mr. Breazzano.

Steve Center, a vice president and fixed-income investment consultant at Callan Associates Inc., San Francisco, said, “I think the effect on the market is going to be quite minimal” because the Fed was “more explicit that they're going to keep short-term interest rates low for the foreseeable future.

The taper is expected to result in higher bond yields, which in turn will improve the bond discount rate, which could get more corporate pension plans closer to becoming fully funded. Mr. Center noted he doesn't believe Fed tapering will directly lead to more pension plan freezes, since plans pursuing an LDI framework already have been well on their way down that road.

PIMCO's Mr. Hodge doesn't agree, at least when it comes to corporate plans. “This is when plans start to think (more) about LDI,” he said.

The certainty of the Fed's announced taper plans seem to have helped avoid a repeat of the springtime market volatility.

“The decision removes much of the uncertainty surrounding the direction of monetary policy in the U.S. and shifts the focus back to the health of the U.S. economy, which continues to show signs of recovery,” Andrew Cole, investment director in Baring Asset Management Ltd.'s global multiasset group in London, wrote in a commentary on the outcome of the Fed meeting.

“If we can get through tapering without the volatility that people were worried about, it will be more about fundamentals,” said WAMCO's Mr. Bellows. n