* Investors seen favoring stocks over bonds in 2013
* Corporate bonds vulnerable in rotation shift
* Bond unwind might halve long-term return on corp debt
NEW YORK, Oct 23 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
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,
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,
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
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