Friday, November 9, 2012

Bond Fund Investors Head Towards the Cliff

Bond mutual funds continue to receive record inflows.

According to Matthew Kelley of Morgan Stanley:

$3.7B of fixed income mutual fund inflows and $3.8B into fixed income ETFs both represent weekly high levels post May 2012.  Year to date, bond mutual fund inflows are trending at a 14% annualized rate, roughly 3x higher than 2011 levels.

And then Michael Hartnett of Merrill Lynch:

Record inflows of $10bn to fixed income funds - insatiable demand for bonds continues  
Largest weekly inflows to Govt/Treasury fund since US debt ceiling debate of Aug'11 - fiscal cliff immediately priced-in via UST.
The chart above shows the path of the yield on the U.S. over the past 20 years. It illustrates, I think, what risks lay ahead for investors focused solely on yield, and not risk.

I think at some point we will see a replay of what happened in the early 1990's.

In the aftermath of the first Gulf War which ended in 1991, the Fed had moved aggressively to push short term interest rates lower.

The Fed had been keeping rates low back then to try to spur the post-war economy. Then, as is true today, investors interested in income fled the relative safety of money market funds in favor of bond funds offering better yields. 

But with higher yields usually comes more capital risk, and when the Fed started tightening monetary policy in 1994 interest rates moved sharply higher, and the prices of bond mutual funds tumbled.

Higher interest rates, of course, push bond prices lower.  If you buy a bond directly, it isn't necessarily a big deal: if you hold your bond to maturity, you will get your original investment back, and you can reinvest at higher interest rates.

However, bond funds usually maintain a constant maturity, and investors can suffer significant capital losses that may never be recaptured.

The 300 basis point rise in interest rates in 1994 was particularly painful for investors in long maturity bond funds, who suffered capital losses of -10% or more in a short period of time.

Money flowed out of bond funds in 1994 almost as fast as it had come in during prior years.  Investors suffered significant capital losses as rates rose, and a whole generation was introduced to the risks of buying bond funds.

Which brings us to today.

The large investor appetite for bond funds today is clearly driven by the desire for income without the perceived riskiness of stocks.  Investors would rather push retirement savings into bond funds offering modest yields without stopping to consider the potential risks involved.

This is particularly true in the junk bond arena, where deals are getting dicier but investor demand remains robust.

I don't know when rates will start to rise.  The re-election of President Obama probably means that Fed Chair Bernanke stays in office for at least a couple more years, and he has pledged that short rates will remain extraordinary low until mid-2015.

However, buying bond funds at record low yields is a tricky business, and the risks in my opinion far outweigh the potential rewards.