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Fed Bond-Buy Cut Fears Sparked Q2 Tumble By Taxables

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Taxable bond funds pulled a sharp U-turn in the second quarter.

"If there was ever a tale of two halves, this has been it," said Rick Rieder. The chief investment officer of fundamental fixed income portfolios for BlackRock was referring to taxable bond fund performance in Q2.

Taxables were on a run through early May. "Since then, especially since Fed Chairman Bernanke's speech, it was downhill," Rieder said.

On June 19 the Federal Reserve chairman signaled that the central bank would trim its bond buys if the economy grows as expected.

Shareholders dumped an estimated $81.4 billion of all types of bond mutual funds and ETFs last month. That nearly doubled the prior single-month record of $42 billion, in October 2008.

"I don't remember a faster 180-degree turn than what happened in the past two weeks," said Rieder, who also is a manager of $6.4 billion BlackRock Strategic Income Opportunities .

The sell-off was also fueled by volatility in Japan, slowing economic growth in emerging markets and signs of a slowdown in China, Rieder said.

By the end of June, taxables had lost 1.98% for the month and 2.22% for Q2, based on preliminary Lipper Inc. data. That was their seventh-worst quarter in 25 years.

Treasury funds' 3.68% Q2 loss was their eighth worst. They lost 2.11% last month alone.

And Treasuries weren't even the worst Q2 performers. TIPS funds tumbled 6.61%. Emerging markets debt funds plunged 6.37%.

The only group to avoid a Q2 setback was one with little rate sensitivity. Loan participation funds inched up 0.11%.

Steeper Yield Curve

The yield curve steepened as the yield on 10-year Treasuries rose 62 basis points to 2.49%, while the yield on two-year notes rose 11 basis points to 0.36%. Ten-year T-notes had gone as high as 2.60% on June 25, their highest since August 2011.

In the closing days of Q2, the Fed went into damage-control mode, emphasizing that it would not trim its stimulus until the economy is strong enough.

Rieder expects the yield on 10-year Treasuries to rise no higher than 3% by year end. "The market has gotten ahead of the Fed," he said, noting that the Fed insists it is not ready to raise interest rates.

Rieder owned a floating rate bond issued by Hilton Worldwide, which matures in about 2-1/2 years and is unrated. The Libor-plus-230-basis-points coupon steps up to Libor-plus-330 in November and Libor-plus-380 a year later.

"The short duration and floating rate protect us against rising rates," Rieder said. "It gets you additional yield because there is no rating. It's low volatility. And it's tethered to real estate, which should have a tail wind of growth."

The bond started Q2 at 100.59, which was Libor-plus-345, and ended at 100.13, Libor-plus-368.

Muni Misery

Tax-exempts had a worse Q2, losing 3.32% after plummeting 3.19% last month alone.

The muni sell-off was orderly for several weeks until Bernanke's June 19 comments made investors think bond-buy tapering was coming sooner than expected, said Geoffrey Schechter, who manages or co-manages five MFS funds with $10 billion in assets.

Investors simply did not want to be stuck with older munis if rates were about to rise, he added.

Still, Schechter expects the sell-off to become orderly again as investors see that the Fed is not beginning its tapering all that soon.

Schechter owned a 5% coupon Houston water and sewer bond, which reflected Q2's volatility. The price of the bond, due November 2036 and rated AA by S&P, began Q2 at 112.74, hit a low of 103.38 on June 25, and closed Q2 at 105.52, for a return of -5.21% vs. -4.35% for the Barclays long-bond index.

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

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

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