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Bonds-Are We Nearing a “Falling Knife” Scenario

By Gary Case

What follows is an analysis of my current thoughts regarding bonds and how they currently fit into most portfolios. As an executive summary, I have removed most bond positions from most portfolios as a precaution against the risk of prices falling due to rising rates or negative investor sentiment. I am moving towards further reducing exposure to high yield bonds and expect to re-establish positions across various bond sectors when conditions appear to me to be more favorable for real returns.

This may be all the information you desire…if so, please feel free to stop reading now. However, if you want to crawl inside my brain (always scary?), please read on. I have gathered information for this article from Advisors Asset Management, Clark Capital Management, and Alliance Bernstein, JPMorgan, and other sources.


What is a falling knife situation?
A slang phrase for a security or industry in which the current price or value has dropped significantly in a short period of time. A falling knife situation can occur because of actual business results (such as a big drop in net earnings) or because of increasingly negative investor sentiment in markets, generally.
*source: http://www.investopedia.com/terms/f/fallingknife.asp

How is this relevant to the bond market you may ask? Currently, we are in what many feel are the final stages of an aggressive bond market rally which has been fueled in part by the Fed’s QE 1/2/3 etc… (scheduled to end next month). Political situations in Ukraine, Gaza, and Iran have commanded the attention of markets. Adding fuel to the geopolitical fire are fears that the Federal Reserve will hike rates more quickly, given a strengthening economy and building inflation pressures. The Fed met in late July and several important takeaways from the FOMC statement were that inflation has moved closer to the Committee’s longer-run objective of 2.0%. Additionally, “the likelihood of inflation running persistently below 2 % has diminished somewhat.” In addition, the statement dropped the reference that the unemployment rate is “elevated.” Several Fed members made the media circuit last week and further rattled the markets with hawkish comments. Dallas Fed President Richard Fisher said the timing of the first rate hike has definitely moved “significantly” closer as a result of the strengthening economy and higher inflation. Meanwhile, Philadelphia Fed President Charles Plosser noted the “considerable economic progress” and said, “The funds rate setting remains well behind what I consider to be appropriate given our goals.” He is making the case for rate hikes sooner rather than later.

Most people agree that rates will eventually go back up; however people continue to disagree as to the “when”. This leads to people continuing to ride the wave and clipping their coupons while they can, because once rates start to move they will just sell. Simple, Right? (Another school of thought in this matter is that actively managed bond portfolios will actually benefit from a rise in rates within a relatively short time-frame, advocating to remain invested and let the rate rise occur…I’m not in this group.)





 

 

This is where things start to get sketchy. If you watched events occur in the municipal market over the past few years when risk-off events occurred, then you have seen a falling knife situation. At the end of 2013 we saw mass liquidations of municipal mutual funds, which left the fund companies with forced liquidations of good positions. At this point you had general public scared, muni funds as net sellers, and dealer desks not wanting to take principle risk unless they got a good deal. What this means is that demand was low, and where there was demand it was only at a price substantially lower than recent prints, establishing a new “market price”. This situation played out last month to a small degree in High Yield bonds, particularly in Exchange Traded Funds. People decided to sell for the sake of selling with no fundamental reasons for doing so.

The situation that we are setting up for could be a whole lot worse. Let’s imagine a scenario where the Fed is completely removed from buying the markets and rates are left to their own devices; supply and demand. At this point one could assume that all these people that have been waiting for rates to go up will start to hit the sell button. This selling pressure will not be limited to the treasury curve, but all products that are spread to it as well. We could see people unloading corporates, agencies, Munis, bond funds, ABS, MBS etc. and willing to do so at whatever price they can get. If this scenario is to occur, where will the bottom be found? If the selloff is fueled by the treasury curve, and foreign economies don’t step in to pick up the slack, we could see a free fall in bond prices as there is no one willing to catch the “falling knife”. Until someone finds a value point you would have all parties as sellers and the “liquid” markets would no longer be such.

This may seem far-fetched and implausible, but is it? We have already seen this occur to smaller degrees in the muni markets recently as well as the broad based markets in ‘08. That collapse was caused by a disruption in corporate and MTG debt and people rushed to the treasury for safety while spreads on risk assets gapped out. The scenario this time will likely be the opposite. It will be the treasury curve selling off causing all risk assets to drop with it. Yield spreads between treasuries, corporate, and high yield bonds are nearly at an all time compression.

These are the opinions of Gary Case and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice.

 


Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Cambridge and Cornerstone Financial Planning are not affiliated.