Rate Hike Leads to Bond Funds' Biggest Withdrawals: 3 Funds to Sell

Time and again we at the Zacks Mutual Fund Commentary section warned investors about the possibility of bond fund exodus once the U.S. Federal Reserve pulls the trigger on rate hike. This turned out to be true last week when bond mutual funds and exchange traded funds saw a record wave of withdrawals. Bond market funds saw the largest redemptions since 1992, when Lipper started tracking the flows.

Remember, a low interest rate environment is favorable for investments in bond funds. This stems from the fact that the market value of a bond is inversely proportional to interest rates. Thus, the rush to pull out money from bond funds was pretty obvious. The U.S. corporate bond market is particularly at risk, as the central bank's rate hike will lead to significantly higher borrowing costs for the lowest-rated companies. Corporate bond prices have also seen significant volatility, as investors find trading in and out of big positions next to impossible without affecting their prices.

The Exodus from Bond Markets

Apprehensions over the stability of the bond market compelled investors to pull out $15.4 billion from taxable bond funds for the week ending Dec 16. High-yield junk bond funds saw an outflow of $3.8 billion during the week. This was the largest outflow since Aug 2014.

Another record wave of redemptions left investment-grade bond funds lose out $5.1 billion. This was the biggest outflow since Lipper started recording data in 1992. Alongside, yields on investment grade and junk bonds shot up to their highest level since 2012, according to data from Bank of America Merrill Lynch.

Tom Roseen, head of research services for Lipper, said: "They were getting out of the way of the Fed." He also acknowledged the recent closure of bond mutual funds and picked on the Third Avenue fund.

He commented: "People are focused on the Third Avenue fund taking it on the chin." New York-based Third Avenue Management had announced that it was closing the high-yield bond mutual fund Third Avenue Focused Credit Fund ( TFCVX ), but its investors will not get their money for "up to a year or more." The move to block redemptions from a Stone Lion credit fund was also playing on investors' minds (read: Third Avenue's Junk Bond Fiasco Reveals Liquidity Risks ).

According to Morningstar data, high-yield bond funds were the biggest losers over the last one week among other Taxable Bond Funds. The high-yield bond funds lost 3.5% in the one-week period and its year-to-date loss is now at 4.8%. Corporate bond funds lost 0.5% over the one-week period and the year-to-date loss stands at 1.2%.

Corporate Bond Funds in Trouble

According to UBS, an astounding $1 trillion of US corporate bonds and loans that are rated below investment grade may be in danger. An USB strategist commented: "It is our humble belief that the consensus at the Fed does not fully understand the magnitude of the problems in corporate credit markets and the unintended consequences of their policy actions."

According to Bank of America Merrill Lynch indices, price of US company debts rated "CCC" had dropped to the lowest level since 2013. Subsequently, the average yield soared to a six-year high. Meanwhile, Moody's noted that the list of companies rated B3 or lower with a negative outlook increased 5% in November to 239. This was a 37% year-on-year increase.

What Increases the Risk for Bond Funds?

A rise in rates may lead to bond exodus; consequently, the lack of liquidity may compel investors to sell the asset class at a significant discount. There is a growing concern that a massive exit from bonds may freeze the markets, as the number of sellers may not match the number of buyers.

Redemption of bonds would increase the sell-off and fund managers would then have to sell the less liquid assets to match investors' cash demands. However, if a mutual fund or an ETF holds illiquid bonds, the price swings will be rapid and would create a vicious cycle as price drops will again intensify selling pressure.

The liquidity risk is of high concern. For bonds, sovereign government bonds are said to be the most liquid. On the other hand, corporate bonds are to suffer the most. New regulations and capital requirements have compelled Wall Street banks to cut their inventories. This has made the buy-and-sell activity of corporate bonds in the secondary market more difficult. The drop in inventories following fresh regulations has created a gap in the number of buyers and sellers. Thus, bond fund managers are now less prone to holding a large chunk of bonds in fear of any possible rout.

The Securities and Exchange Commission had proposed a rule earlier this year that mutual fund companies must disclose how vulnerable their bond portfolios are to rate hikes. This was among SEC's first moves to address concerns that the first rate hike in about seven years may spark a rapid sell=off in bond funds, resulting in steep losses.

3 High-Yield Bond Funds to Avoid

Increasing concerns over bond funds will only intensify as the central bank opts for a gradual hike in rates. Thus, investors looking for safer avenues should exit from certain high-risk high-yield bond mutual funds.

Below we highlight 3 mutual funds from the High Yield bond fund category that carry a Zacks Mutual Fund Rank #4 (Sell) or Zacks Mutual Fund Rank #5 (Strong Sell) as we expect the funds to underperform their peers in the future. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but the likely future success of the fund.

These funds have negative returns year-to-date and over the last 1-year period. The 3-year annualized return is also in the red. The minimum initial investment is within $5000.

Northeast Investors Trust ( NTHEX ) focuses on investing in marketable securities of prominent firms. NTHEX primarily purchases debt securities rated below investment grade by any of the two major ratings firms.

Northeast Investors Trust currently carries a Zacks Mutual Fund Rank #5. Over year-to-date and 1-year periods, NTHEX has lost 17.8% and 17.7%, respectively, and has a negative 3-year annualized return of 4.2%. Annual expense ratio of 1.09% is higher than the category average of 1.06%. NTHEX's 85.59% of assets is allocated to bonds.

Franklin High Income A ( FHAIX ) invests mostly in lower-rated debt securities that provide high yield. These lower-rated securities include bonds, debentures, convertible securities and other debt securities. The fund seeks a high level of current income.

Franklin High Income A currently carries a Zacks Mutual Fund Rank #5. Over year-to-date and 1-year periods, FHAIX has lost 11.8% and 10.9%, respectively, and has a negative 3-year annualized return of 1.9%. Annual expense ratio of 0.76% is lower than the category average of 1.06%.

Consulting Group High Yield Investments ( THYUX ) seeks a high level of current income by investing in below investment grade debt securities. THYUX focuses on investing most of its assets in domestic junk bonds. THYUX may utilize 20% of its assets to purchase high yield bonds of issuers located in emerging or developed economies. Average portfolio duration of THYUX is from two to six years.

Consulting Group High Yield Investments currently carries a Zacks Mutual Fund Rank #4. Over year-to-date and 1-year periods, THYUX has lost 8.4% and 7.6%, respectively, and has a negative 3-year annualized return of 0.4%. Annual expense ratio of 0.74% is lower than the category average of 1.06%.

By applying the Zacks Rank to mutual funds, investors can find funds that not only outpaced the market in the past but are also expected to outperform going forward. Pick the best mutual funds with the Zacks Rank.

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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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