T-Bonds, Other Taxables Gained In Q1; Munis Jumped

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Federal Reserve chair Janet Yellen rocked the markets with three words.

In her March 19 press conference she said the central bank would start to raise short term rates in perhaps "about three months" after the end of tapering.

The market turned somersaults. "It was seen as a change in Fed guidance, moving up potential rate hikes by about six months, so it actually made short-term rates rise a bit," said Jay Mueller, senior manager of $699 million Wells Fargo Advantage Short-Term Bond Fund .

That volatility held taxable funds overall to a modest 0.16% gain on average for March, according to preliminary Lipper Inc. data. That cut their advance for the first quarter to 1.97%. Emerging markets local-currency debt funds led the way last month. Their 1.20% gain boosted their Q1 return to 2.44%.

Treasury funds lost 0.14% in March, trimming their Q1 rise to 3.63%. In January, Treasury funds jumped 3.29%, spooked by signs of investor flight from emerging markets amid currency and growth concerns. Risk appetite returned in February as investors hammered just the few emerging markets they decided were at greatest risk.

In March, Ginnie Mae funds lost 0.40%, limiting their Q1 gain to 1.70%.

Damage Control

The damage to taxables was already done by March 31, when Yellen said the Fed would not raise rates soon.

On longer Treasuries, prices got pushed up by global events -- the slowdown in China and Russia's invasion of Crimea.

So as the yield on 10-year notes fell 31 basis points to 2.73%, the yield on two-year notes rose 7 points to 0.45%. That flattened the yield curve in Q1.

Mueller's outlook calls for more of what investors saw in March. "Rates are going up, though gradually," he said. "And the Fed will stay the course."

He expects the Fed to start raising short-term rates around midyear 2015. That timetable is now built into the market, said Mueller, also senior portfolio manager of $1.9 billion Advantage Ultra Short-Term Income .

All along the curve, Wells Fargo favors investment-grade corporates. In the short end of the market -- bonds with maturities of one to five years -- Mueller continues to favor commercial mortgage-backed securities.

During Q1 he owned an investment grade, five-year bond fromVerizon Communications ( VZ ), rated Baa1 by Moody's, maturing Sept. 14, 2018, with a 3.68% coupon. Its price in Q1 rose to 106.45 from 105.86, for a total return of 1.41%, reflecting investor appetite for shorter maturities. "And it's a big issue that's well known," Mueller said.

Tax-exempt bond funds were up 3.24% on average in Q1, after eking out a 0.16% March gain.

Yellen's remarks hit munis, especially on the short end, as well as taxables. Investors interpreted Yellen's comments to mean the Fed would raise short-term rates sooner than expected. As many investors exited short-term debt, yields and rates rose, said Christopher Ryon, co-manager of three Thornburg funds, including $6.6 billion Limited-Term Muni .

For munis overall in Q1, low supply helped boost prices. New issuance was down about 35% vs. last year, Ryon said. And demand was up. Muni bond funds had 10 weeks in a row of net inflow through March 19, according to the Investment Company Institute. That followed 33 straight weeks of outflow.

Ryon thinks muni funds already have scored their price gains for the year. "I don't expect any great capital appreciation going forward, just earning your income," he said.

Ryon was also concerned about Puerto Rico, despite its successful $3.5 billion bond sale in March. Ryon warned that he expects the island to be forced to restructure its debt within a few years. And he disagrees with the Commonwealth's claim that the recent issuance is senior to outstanding legacy debt.

Detroit is another potential problem area if the bankruptcy court forces bondholders to take a proportionately bigger haircut than pensioners do. That decision could come within 90 days.

He owned a bond for the Poseiden desalinization plant in Southern California. Maturing in 2045, it was rated Baa3 by Moody's, has a 5% coupon and is callable July 1, 2022, at par. Soaring 14.72 in price in Q1, it returned about 19.5% vs. 3.8% for the BofA Merrill Lynch U.S. Muni Index. It benefited from investor flight from short-term bonds.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Mutual Funds

Referenced Stocks: VZ

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