Republished from: “Barron’s”

July 23, 2013, 11:40 A.M. ET
BofA: Annual Losses Likely For High-Grade Corporate Bonds
By Michael Aneiro

Bank of America Merrill Lynch today says Ben Bernanke’s most important accomplishment over the past few weeks has been “to significantly reduce the market’s perception of upside tail risk for longer term interest rates,” with interest-rate volatility down by a third since early July. BofA credit strategist Hans Mikkelsen looks at the implications for investment-grade corporate bonds:

For credit spreads this decline in upside tail risks is important, as we are still significantly below the 3.5% level on the 10-year that the typical high grade investor believes will trigger a disorderly rotation – i.e. wider credit spreads due to outflows – if reached over the next three months…. Our baseline view is for gradually increasing interest rates and a continued orderly rotation out of high grade bond funds with tighter credit spreads.

But BofA still says it worries about shorter-term volatility and the implications of higher rates in the longer term:

What keeps us up at night is still interest rate risk. What makes us concerned about meaningfully higher interest rates is upside risk to the economy from the housing market. One would think that the housing story is priced in – but why then do home prices continue to surprise to the upside? In fact, the magnitudes of upward surprises appear to be accelerating …. We look for 3.0% [yield] on the 10-year [Treasury] by year-end and 4.0% by the end of 2014. Such a path for interest rates is likely unkind to high quality, long duration, fixed coupon total returns.

BofA expects high-grade corporate bonds to post further total return losses this year on top of the -2.6% year-to-date losses, as well as further losses next year, meaning consecutive years of “meaningful negative total returns,” noting that high grade corporate bonds have seen annual negative total returns only six times the 41-year history of a key index, and never in consecutive years. More from BofA:

While, again, our baseline view is for an orderly rotation – and that assumes a rather gradual, linear increase in interest rates – clearly the next couple of years will be more challenging for high grade bonds than we have seen in environments with inflows. We are very concerned that interest rates will not increase gradually, but in bursts and overshoot at times…. Such a move could lead to an acceleration of outflows from high grade mutual funds and ETFs, leading to wider credit spreads.

The iShares iBoxx $ InvesTop Investment Grade Corp. Bond Fund (LQD) is down 18 cents so far Tuesday to $115.27.