U.S. bond market near end of bull run-BofA Merrill Lynch analyst

Tue Oct 23, 2012 1:02pm EDT

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NEW YORK, Oct 23 (Reuters) - The U.S. bond market is in the "final inning" of a three-decade bull run, with investors likely to pile into stocks and withdrawing from bonds in 2013, a Bank of America Merrill Lynch analyst said.

It is only a matter of time until interest rates rise from historically low levels, which are "not in a natural state," Hans Mikkelsen, Bank of America Merrill Lynch's senior credit strategist, wrote in an Oct 22 research note released on Tuesday.

The European debt crisis, sluggish U.S. economic growth and the Federal Reserve's unprecedented easy monetary policy have pushed interest rates and bond yields to ultra low levels, Mikkelsen said.

He cautioned that a long-term rise in interest rates would hurt U.S. corporate bonds, which have enjoyed double-digit gains this year as investors scoured the market for higher-yielding debt in the current rock-bottom rate climate.

A tame default rate on corporate debt, even junk bonds, also helped returns this year.

"Thus it is only a matter of when - not if - interest rates start increasing. It is also only a matter of when the great rotation trade out of bonds and into equities starts," Mikkelsen said in the research note.

He outlined two scenarios. An "orderly" rotation, which is most likely, would involve persistent flows of money into bond funds in early 2013, followed by slower flows during the year and modest outflows by the end of the year.

A "disorderly" rotation due to a rapid jump in interest rates from a fast improving U.S. economy would cause a stampede from bond funds. This would result in a significant increase in risk premiums on corporate bonds and hurt their total return, Mikkelsen said.

To be sure, appetite for U.S. bonds especially corporate bonds has remained high.

In the week ended Oct 17, investors socked $2.4 billion into investment-grade corporate bond funds, the most on a record that spans nearly 21 years, according to fund data firm Lipper. Of that amount, $1.41 billion went into investment-grade corporate bond mutual funds, and the rest was put into exchange-traded funds.

During this 30-year bull run in the U.S. bond market, the average annual total return on U.S. investment grade corporate bonds has been about 10 percent, not far behind the 12 percent return on stocks, Mikkelsen said.

So far in 2013, investment grade bonds have returned 10 percent, while junk bonds have earned a 12 percent return.

Still whenever U.S. interest rates rise back toward their historic averages, that will erode the gains corporate bonds have enjoyed during the current bull market run, he said.

The decline in 10-year interest rates since the end of 1981 has averaged 0.40 percentage point a year to below 2 percent from 14 percent. This movement has accounted for 2.5 percentage point average annual gain in corporate bonds, he said.

An unwinding of this rate decline alone over the next 30 years could halve the annual average return on corporate bonds to 5 percent from the current 10 percent, according to Mikkelsen.

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