Bond Market Selloff Triggers Major Quarter-End Portfolio Rebalancing

A severe third-quarter selloff in the bond market, which contrasted sharply with equities lingering near record highs, is expected to force one of the most significant quarter-end portfolio rebalancing events in years. Investment managers are now undertaking large-scale trades to bring their asset allocations back in line with their strategic targets.

A Historic Allocation Shift

The divergence between falling bond prices and stable stock values has left many portfolios, which adhere to a specific ratio of stocks and bonds, significantly misaligned. This has magnified the need for routine quarterly adjustments, which are a core risk management discipline for institutional investors and financial advisers.

"I do think this quarter will be as significant a rebalancing as anything we’ve seen historically because volatility is higher and because of how significant the drift away from target allocations has been," said Jordan Jackson, global markets strategist at JP Morgan, in a comment to Reuters. The bond market's deterioration sparked the largest quarterly increase in the yield of the 10-year Treasury bond since the second quarter of 2009.

Pension Funds to Drive Market Flows

The rebalancing activity is expected to create substantial flows that could weigh on stocks and support fixed-income markets as the fourth quarter begins. According to a Goldman Sachs report, the scale of this shift is notable.

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• U.S. pension funds alone were projected to sell $33 billion in stocks around the end of the quarter to rebalance their holdings.
• This estimate places the quarter in the 98th percentile for the absolute dollar value of such rebalancing flows going back to January 2000.

While the full effects will become more visible in the coming days, Jackson said he has already spotted signs of rebalancing in recent mutual fund and ETF flows, with investors emerging as bigger buyers of bonds.

The Investor's Dilemma

Analysts acknowledge the psychological challenge for investors in selling high-performing assets to purchase those that have been losing value. "People should be more aggressive than usual in rebalancing, because the selloff in Treasury bonds is creating a more attractive opportunity than we’ve seen in decades, while stocks look pretty pricey," commented Michael O’Rourke, chief markets strategist at JonesTrading.

This behavioral hurdle is a common theme. "The biggest challenge is behavioral," said Mike Casey of AE Advisors. "Clients naturally want to let winners run." However, large institutional managers are proceeding with the discipline. Michael Gates, lead portfolio manager for BlackRock’s Target Allocation ETF model portfolio suite, confirmed he is overseeing rebalancing to manage risk, stating, "We’re keeping our risk in line by not allowing our models to get too overweight stocks at this stage."