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Wall Street Pros Grow More Bearish on Bonds

by Stephen Taub

Most bond pros are more bearish on bonds than they have been in recent months.

According to an August Merrill Lynch global survey of fixed-income money managers, conducted after the recent bearish payroll figures were published, more than eight of 10 (81 percent) said they believe the bond market is overvalued (thus, headed for higher rates, lower prices). This is way up from 62% who felt the same way the prior month and 49% in June.

Just 7% said they believe the global bond markets are undervalued.

Merrill Lynch surveyed 89 Global Fixed Income Fund Managers from the U.K., Continental Europe, Japan, and the U.S.

The most bearish are the Japanese; 92% believe the bond markets are overvalued.

On the other hand, US-based fixed-income managers are apparently the most upbeat, if you can call it that.

"Just" half believe the markets are over-valued. What's more, 17% said the markets are undervalued, more than triple the amount that felt this way among managers based in continental Europe and more than quadruple the sentiment among those working out of the United Kingdom.

Managers are widely divided about where they perceive investment opportunities to be over the next 12 months.

For example, a majority (58%) of Japanese managers expect corporate/high yield bonds to outperform government (sovereign) bonds while 50% expect inflation-linked bonds to outperform conventional bonds.

US-based managers, however, disagree. An overwhelming majority (83%) said they don't expect corporate/high yield bonds to outperform government (sovereign) bonds while 58% don't expect inflation-linked bonds to outperform conventional bonds.

In some areas, however, managers throughout the world seem pretty much in agreement.

For example, most of the managers seem to concur that in 12 months, short-term interest rates (three-month paper) will rise "slightly" as opposed to "a lot higher" or "unchanged." No one expects rates to drop.

Interestingly, though, 21% of global managers expect long-term rates to be "a lot higher," led by those based in Europe or the UK. Yet, no US-based managers agree.

In fact, three-quarters of US managers only expect long-term rates to climb "slightly" while another 17% expect them to be "unchanged."

Bond managers, however, aren't the only ones who are unenthusiastic about bonds.

Strategists from the major investment banking firms are also uninspired.

For example, despite weaker-than-expected jobs growth and consumer spending, Merrill Lynch still favors stocks over bonds. One reason is that it believes the Federal Reserve will stick to its plan to raise rates throughout the rest of the year, and end the year with a Federal Funds rate near 2%.

"We continue to maintain that an overweight position in equities and an underweight position in bonds, although painful of late, is still the place to be," said Bob Doll, President and Chief Investment Officer of Merrill Lynch Investment Managers and its investment advisory affiliates, in a recent weekly report.

The fixed-income folks at UBS Securities are also not too excited about the prospects for bonds. They're not outright bearish, but they note in a recent report to clients, "Given emerging concerns over the sustainability of the current expansion and increased financial market volatility, bonds could remain in fairly narrow ranges through the balance of the third quarter."

UBS recommends that accounts retain a below-average duration weighting through the balance of the year.

And, on every class of security, UBS has either negative or neutral outlooks, and recommends either underweight or market weight allocations.

The only exception is mortgages. UBS has a "positive" sector outlook and recently increased its recommended allocation to "modest overweight" from "slight underweight."

Why does the investment bank single out mortgages as its favorite sector?

For one thing, UBS asserts that the percentage of mortgages that are refinanceable remains low. "We are no longer concerned that volatility is more likely to rise than to fall," it adds in a recent report. "It has already risen significantly, and two events--the employment report and the August Fed meeting--are done. Moreover, mortgages historically do well in Treasury refundings." 

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.