Bloomberg -- Institutional investors allocations to dollar-denominated bonds have dropped to the lowest level since 2007 as strategists at Morgan Stanley and JPMorgan Chase & Co. see a shift away from the debt that may fuel higher borrowing costs.
Holdings by investors from pensions to endowments fell to 26.2 percent of assets in the second quarter, from 30.1 percent in the corresponding period of 2012, according to the Wilshire Trust Universe Comparison Service, which tracks plans that oversee $3.46 trillion. Morgan Stanleys $1.8 trillion wealth management unit has been advising clients to cut bond allocations to the lowest in more than five years, Chief Investment Strategist David Darst said.
Dollar-denominated corporate, mortgage and government bonds, facing the biggest losses since 1994 this year, may be headed for deeper declines as investors sour on the debt. While Federal Reserve Chairman Ben S. Bernanke attributes rising yields partly to confidence in the economic recovery, higher borrowing costs are unwelcome, he said in July testimony before Congress.
Equities will outperform bonds over a seven-year timeframe because bond yields are already so low, Darst, who oversees investment strategy at Morgan Stanley Wealth Management, said in a telephone interview. Weve got a slight underweight in junk bonds. We have a big underweight in corporate and government bonds.
U.S. Treasury yields reached 2.74 percent on July 5, the highest levels since August 2011, with investors seeing better opportunities in equities. Speculative-grade notes yield 6.19 percent, almost the same as the 6.14 percent earnings yield on the Standard & Poors 500 Index of stocks.
While yields on dollar-denominated corporate, government and mortgage debt have risen 0.8 percentage point since year-end to 2.33 percent, theyre still 1.5 percentage-points lower than the average over the past 10 years, Bank of America Merrill Lynch index data show. The debts 2.6 percent loss this year compares with a 20 percent gain on the S&P 500.
Billionaire Warren Buffetts Berkshire Hathaway Inc., which owns stocks valued at more than three times its bond holdings, reported a 2 percent gain in book value in the second quarter. Buffett told investors in February 2012 that bonds were among the most dangerous assets.
American International Group Inc., the insurer that repaid a U.S. bailout last year, said the surge in interest rates in the second quarter fueled a $9 billion reduction in its bond portfolio. That contributed to a 2.1 percent decline in book value.
An extremely low-yield environment forces people to take risk, Sheila Patel, a managing director at Goldman Sachs Asset Management, said yesterday in a Bloomberg Television interview. Doing nothing is risk because there are targets to be met and pensions to be paid.
Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. fell, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, declining 0.7 basis point to a mid-price of 75.6 basis points as of 8:53 a.m. in New York, according to prices compiled by Bloomberg.
The measure typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
The U.S. two-year interest-rate swap spread, a measure of debt market stress, was little changed at 17.63 basis points as of 8:53 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.
Bonds of Royal Bank of Canada are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 6.9 percent of the volume of dealer trades of $1 million or more as of 8:53 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Institutional investors such as corporate and public pensions have reduced their median allocation to U.S. bonds from 32 percent of their assets in the last three months of 2011, according to data compiled by Wilshire Associates Inc., whose Trust Universe Comparison Service tracks more than 1,700 plans.
The current proportion of dollar-denominated debt holdings is the least since the fourth quarter of 2007, Kim Shepherd, a spokeswoman for the firm, said in an e-mail.
There is movement by institutional investors out of investment-grade bonds, said Eileen Neill, a managing director in the consulting division of Wilshire, a Santa Monica, California-based financial advisory firm. Its not out of fear of bonds, its out of necessity because of the low yields. Theyre moving to higher yielding bonds and emerging markets debt.
Individual investors have been shifting to stocks from bonds as well. The gap between flows into bond mutual funds and exchange-traded funds and those focused on equities widened to $70 billion in June, the most ever, according to JPMorgan analysts led by Nikolaos Panigirtzoglou in London.
Retail investors have embraced the Great Rotation over the past two months, they wrote in an Aug. 7 report. It represents the biggest behavioral change by retail investors since the Lehman crisis.
Yields are rising from record lows as U.S. central bankers debate slowing monthly bond purchases, which have pumped about $2.6 trillion into the financial system since the failure of Lehman Brothers Holdings Inc. deepened the 2008 credit seizure. The 2.6 percent loss this year in dollar-denominated corporate, government and mortgage debt compares with a 3.8 percent gain in the same period of 2012 on the Bank of America Merrill Lynch U.S. Broad Market Index.
Morgan Stanley Wealth Management changed its recommendation to moderate high net-worth clients in March, advising them to place 30 percent of their money in bonds and 42 percent in stocks, Darst said. Last year, the advice was reversed, with 42 percent in bonds and 30 percent in stocks. The firm would consider further decreasing the allocation to debt if strategists sensed that interest rates were poised to rise more quickly, he said.
If we felt that we were going to have a quick move over the next year or two, I think the inclination would be to reduce it even further to move it into cash and then back into bonds or into stocks, Darst said. Its important to have some debt holdings because there is deflation risk and you want to have some insurance in case youre wrong.
Bond issuance is slowing as borrowing costs increase. While U.S. companies and government entities sold debt at the fastest pace since 2009 in the first half of the year, this months $29.7 billion of sales is 6.3 percent less than during the same period in 2012, Bloomberg data show.
U.S pension funds and insurance companies have been steadily accepting higher equity allocations and lower bond allocations since the third quarter of 2011, JPMorgan global asset allocation strategists wrote in the Aug. 7 report. The trend accelerated in the first quarter, they wrote.