Analysis - U.S. bonds surprise by hanging tough after rough summer

By Richard Leong

NEW YORK (Reuters) - The U.S. bond market is enjoying a resurgence, to the surprise of investors who just weeks ago were resigned to the idea that 2013 was going to be the worst year for bonds in more than three decades.

While the Treasury market is still on the hook for a weak year, junk bonds and a few other sectors are set to end with respectable gains after surviving a turbulent summer driven by fears the Federal Reserve would start to dial back stimulus.

"Major government bond markets have entered into a long-term bear market. You need bonds that hold up well in a rising rate environment," said Kristina Hooper, head of investment and client strategist at Allianz Global Investors in New York, which manages $409 billion in assets.

While bond investors can breathe a sigh of relief for now, the outlook for next year is still not for the faint-hearted. U.S. bond investors will need to hedge against the inevitability that sooner or later U.S., European and Japanese central banks will unwind their unprecedented stimulus to bolster their economies. But that means investors would need to take greater risks.

The U.S. central bank - which sparked a massive selloff in bonds in the late spring by signalling its intent to shrink its $85 billion monthly purchases of Treasuries and mortgage-backed securities - spurred a reversal in those markets after it chose not to cut the program at its September meeting, a position reiterated at its October gathering.

Benchmark U.S. 10-year Treasury yields then fell as much as 0.50 percentage point from a two-year high of 3 percent, providing a shot in the arm for U.S. bond mutual funds. They were quoted at 2.61 percent late on Thursday.

In the first eight months of the year, only 20 percent of the 1,651 bond funds tracked by Lipper, a unit of Thomson Reuters, had earned a positive return. Since then, that share has jumped to 32 percent.

Junk, or high-yield, bonds have racked up a 6.4 percent gain so far this year, according to Bank of America Merrill Lynch. The sector suffered heavy losses in May and June on the Fed's hints about cutting its stimulus.

Somewhat less risky bank loans, as tracked by Standard & Poor's, have returned 4.5 percent, while investment-grade U.S. corporates have lost 2.07 percent so far in 2013.

Treasuries and other government-related debt are a different matter, despite the recent decline in yields. They are almost certainly doomed to a weak year.

"Treasuries and agencies will continue to struggle," said James Sarni, managing principal at Payden & Rygel in Los Angeles, which oversees $80 billion in assets.

U.S. Treasuries have lost 2.4 percent so far this year, and are on track for their steepest annual loss since 2009. Agencies - bonds from the likes of Fannie Mae and Freddie Mac - have declined 0.85 percent, according to bond indexes compiled by Bank of America Merrill Lynch.

But if Friday brings a poor set of October jobs figures, it may rekindle a rally in bonds, bringing benchmark 10-year Treasury yields toward 2.25 percent. At that level, the 2013 performance of investment-grade corporate bonds and mortgage-backed securities - whose prices are influenced by Treasuries - would probably be salvaged, erasing their losses on the year.

"You'd do better than break-even if that happens," said Jeffrey Rosenberg, chief investment strategist for fixed income at BlackRock, which manages $3.79 trillion in assets.

<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

Graphics:

U.S. Treasury yields http://link.reuters.com/gar98t

U.S. Treasury yield spreads http://link.reuters.com/kar98t

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

NOT TAKING CHANCES

Still, the autumnal renaissance might be too late for those bond fund managers whose ledgers are swimming in red.

Fed policymakers, who have cooled speculation of an imminent reduction in bond buying, have not abandoned the notion they might do it in the first half of 2014. Such a move would stoke speculation that they will map out a timetable for an eventual hike in interest rates, which have been near zero since December 2008.

Whenever the Fed starts to reduce its stimulus, Treasuries are likely to bear the biggest brunt of the selling.

"It's not a matter of 'if' but 'when,'" Payden & Rygel's Sarni said. "Treasuries are not a good place to be when rates rise."

Some investors have responded by scaling back bond holdings, withdrawing $78 billion from bond mutual funds since May, compared with the $35 billion they socked into stock funds, according to the Investment Company Institute.

Even the Pimco Total Return Fund, the world's biggest bond fund, has not been immune. It has seen outflows for sixth straight months, reducing its assets to $248 billion from $293 billion in April, according to Morningstar.

ROTATING INTO RISK

Even though Treasury yields have risen, benchmark yields are still stuck near historic lows. Insurance companies, pension funds and other long-term investors hungry for steady income to meet billions of dollars in annual payout obligations have shifted money out of low-yielding bonds and into higher-yielding ones, fund managers said.

"Many of our pension fund clients are worried about rates going forward. They and our institutional clients have been rotating into high-yield bonds and leveraged bank loans," said Keith Bachman, head of U.S. high-yield with Aberdeen Asset Management in Philadelphia which has $312 billion in assets.

Bachman, who expects junk bonds to earn 7 to 8 percent this year and again next year, said they are good vehicles for those who want to invest in bonds because they have enough cushion even if yields head moderately higher in coming months.

Junk bonds are offering an average yield premium of 4.80 percentage points, compared with a historic average range of 3.50 to 4 points, Bachman said.

(Reporting by Richard Leong; Editing by Martin Howell and Nick Zieminski)