Why Do Investors Continue to Pour Money into Bonds?

According to this report from Morningstar, investors continue to pour money into fixed income funds and out of equities. Amazingly though more money has come into the market this year then was pulled out in 2008, but just about all of the gains went directly into bonds. Anybody think the retail investor is right this time?

With the economy starting to recover and interest rates at record lows, it seems like an odd time to be invested in bonds. Do people realize that bond funds lose money as interest rates rise? Bonds are the worst investment in rising rate environments. Wanna bet that the media convinced everybody that the market had come too far, too fast going into September/October. That bonds offer safety in a volatile environment. That bonds did better during the crash. Poor sheep listened again.

Also, most people don't understand the difference between a bond and a bond fund. A bond in theory doesn't lose value as long as your willing to hold till maturity. You collect the payments and don't really care about the trading value. Unless of course you've got a bond from some company about to stop paying. That's a completely different discussion though. A bond fund on the other hand is all about trading value. Its value is updated daily based on what you could sell the bonds for at the closing each day. Basically mark to market versus hold to maturity. Mark to market can be brutal as we saw last year.

Back to the details of the report:

• Most of the money flowing into fixed income funds came from the record $3.6T in money market accounts in January. That total is now down to a still very high $3.2T.
• Bond funds had an inflow of nearly $42B in October and $296B YTD.
• Equity funds had a $3B outflow in October and only $12B inflows YTD.
• Domestic equity funds were decidedly negative with net outflows YTD of over $4B.
• International equity funds fared much better with inflows of $16B YTD.

This leaves one to wonder what happens when money flows into equities and domestic funds in particular. Even though stock markets are up huge off the lows, nobody has been convinced to join from the sidelines. As we wrote about the Yield Curve in our previous article, this might sum up why equities tend to do well in the initial phases of interest rate hikes by the fed. All this money in fixed income is likely to come flooding out as bonds begin losing value. The money must find a home with the options of either next to nothing in money market accounts or the 'promise' of big returns in equity funds (nobody tell them that they are late to the party yet again).

P.S. Just don't tell these party crashers until I have my clients money out of the market.

Disclosure: Fully invested in domestic and international stocks

Comments

[prairiedog555:]

I am invested in CEF's that hold foreign currencies. TEI GIM JGT MIN
It seems that they have fared OK in rising rate enviorments in the past.
What do you think of these funds as an investment in a rising US interest rate scenario?

Nov 13 08:45 AM

[Stephen Ros...:]

Finally someone is differentiating the risks between holding individual bonds and bond funds. The first requires thought and the promise of a steady pay out while the second gets slaughtered by fees, interest moves and the vagaries of the market.

Nov 13 10:00 AM

[Gtarras:]

retiring or about to retire baby boomers, who control most of the capital, are looking for safer havens compared with equity. i'm not surprised to see money flowing into bond funds. the process will probably continue, as they are looking to park their cash for a long time and use it over years to come. their trust in the market been destroyed after all the bubbles of the past ten+ years. on top of it, while the Fed is about to stop treasury purchases, the new class of buyers is stepping up- the banks. according to WSJ, current holdings of tresuries by banks is at record low of 1.5% overall assets, and the goal is to raise it to long-time average of 9-10%. dont ask me who is mandating the bankers to buy treasuries.

having said that, i am not advocating to go long bonds. quite the contrary, waiting for the right moment to buy TBT. but i think this moment will come much much later than most people realize, maybe years. for the above reasons. all IMHO.

Nov 13 10:00 AM

[richard_e_n...:]

Most people do not know that they are getting negative yields because they think that there is no inflation or worse - think that there is deflation. Supporting this view was the latest (Sept 2009) year over year inflation number on the CPI-U all-items of minus 1.32%. This makes it look like you are getting a real return of 1.31% on a .01% 30 day T-bill. The problem is that the year over year number is a LAGGING indicator. Actual, current, CPI-U, all-items inflation is 2.66% giving you a real return of -2.65% on a 30 day T-bill with a nominal .01% interest rate. I am amazed that main-stream economic reporters always cite the lagging indicator instead of CURRENT inflation - you know, first derivative inflation. They get this right when reporting unemplyment, but fail when reporting inflation. I don't get it!

Nov 13 11:52 AM

[Daniel Boone:]

Dear SFC,
What about TIPS ? Obviously for tax reasons for most people this a fund position to hold only in a tax deferred environment.

My current CREF Inflation Protected Bond Fund holdings are returning 9+% YTD & 4th qtr is running 24% with CPI @ 2.66%.

Regards to all,

Dan

Nov 14 06:40 AM

[Old Trader:]

While true that bonds/fixed income suffer in a rising interest environment, it appears that time is not quite yet upon us, as central banks, by and large, are keeping rates low.

When investing in any fund, whether bond or equity; open end or closed end, one is making a bet on the management of the fund, as well as the sector. Templeton has an excellent track record.

Disclosure: Long GIM and TEI

Nov 14 09:22 AM

[User 410955:]

Financial colunmist Chuck Jaffe wrote a good article earlier this year and I agree totally.. It pertains to folks who should not be "betting the farm" on equities if: They are nearing retirement and their portfolio's balance is approaching their goal. Understandably, if one has been invested in a broad range of equities over the past decade, the only way to offset 10 years of treading water (at best) is to 'roll the dice" via equity investing in order to have a chance at some large gains. If your portfolio is nowhere near where it needs to be...you probably have to take on a fairly large degree of risk for the possibility at growing the balance significantly. Bonds and bond funds will never get you there but there are brief periods of anomalies such as recently. Tips funds, junk bond funds, and investment grade bond funds have gained enormously over the past 18 months or so. This is where I have been invested since before the market crash. I am only a few years away from retirement and can achieve my portfolio balance goal with modest returns. I will settle for small returns as opposed to being ready to retire and having the rug pulled from beneath me via stocks and stock funds. If I miss a monster run-up as of late....so what? I have been sleeping like a baby for the past decade. Equities served me well during the 80's and 90's. I went into bonds and bond funds for the most part just prior to the tech bubble collapse and I am not sorry one bit. I 'bet the farm" when I had the opportunity (time frame) to build another one if it burnt down. Now the farm is nearing completion and I will wait to receive the rest of lumber one board at a time.

Nov 15 07:51 AM

[Gary A:]

People are preserving capital because 1. the Fed scared them with the crash. and 2. they don't want to lose in another crash because they are getting older and won't be able to earn that money back.

Bernanke is a bond salesman and wants the bonds purchased. He has a lot of them to sell. As soon as people go all into this stock market it may crash again. It is a bubble market, and so are bonds. And so are assets. Oil is priced at close to twice per barrel of what it is really worth based upon a normal dollar and low demand.

Since everything is a bubble I have heard that many have a short position to protect on the downside.

Nov 15 10:33 AM

[MrLucky:]

I think there is a general perception that the equity market is a rigged casino that bears no resemblance to the market of the imagination. Nor is it connected in any meaningful way to the underlying economy. It's just a place to gamble, unless you're Goldman, of course. ;-)

Nov 15 09:42 PM

[Archman Inv...:]

<<P.S. Just don't tell these party crashers until I have my clients money out of the market.>>

You don't have any "real" clients. You have a blog masquerading as a money management firm, and you manage money for your parents.
LOL.

Nov 19 11:10 PM