Moving Into Bonds: From Frying Pan to Fire

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by David Galland: Who's
Scoffing Now?

 

 
 

The other
day, I came across an article that said, while individuals may be
moving their money out of equities, they have been moving into bond
funds – and in a big way.

It’s
called jumping from the frying fan into the fire.

Based on
my experience as a co-founder of a mutual fund group, I can tell
you that if there is one sure thing in this world, it’s that
when investors rush en masse into an investment category, it is
invariably at almost exactly the wrong time to do so. Is that the
case with today’s rush into bonds?

To shed
some light on that point, Casey Research Switzerland-based editor
Kevin Brekke volunteered to look into the correlation between bond
flows and performance. Here’s his report…

Thinking
About Bonds

By Kevin
Brekke

With the great
bond stampede that began in 2009 continuing, giving rise to the
very real possibility of a bond bubble, we decided to check the
relationship between bond returns and bond fund inflows to see if
there might be a correlation. Take a look at this chart:

  1. Measured
    as the year-over-year change in the Citigroup Broad Investment
    Grade Bond Index.
  2. Plotted
    as the three-month moving average of net new cash flow as a percentage
    of previous month-end assets. The data exclude flows to high-yield
    bond funds.

As suspected,
the rise and fall in total return from bond funds is accompanied
by an influx or exodus of bond investors. Data to construct the
chart were taken from the Investment Company Institute’s (ICI)
2010 Fact Book
where they state,

In 2009,
investors added a record $376 billion to their bond fund holdings,
up substantially from the $28 billion pace of net investment in
the previous year. Traditionally, cash flow into bond funds is
highly correlated with the performance of bonds. The U.S. interest
rate environment typically has played a prominent role in the
demand for bond funds. Movements in short- and long-term interest
rates can significantly impact the returns offered by these types
of funds and, in turn, influence retail and institutional investor
demand for bond funds.

ICI continues
by noting that secular and demographic trends have tempered the
appetite for equities. An aging population tends to become risk
averse, and the Baby Boomers are entering retirement and seeking
a safer alternative to the stock market. This occurrence is clearly
shown on the right side of the chart. Following the stock market
crash in 2008, investors exited stocks and bonds as general panic
prevailed. As investor calm returned, a tidal wave of new money
flowed into bond funds, turning 2009 into a record year.

And the popularity
of bond funds continues. So far this year, investors have funneled
$200 billion in new money into bond funds. 2009 was also a record
year for total assets and net new capital in bond funds from retirement
accounts.

That is the
view through the macro lens. Switching to a wide-angle lens gives
one pause.

We can’t
help but draw similarities to the housing bubble that began inflating
at the start of the new century. As home prices started escalating,
they drew the attention of a growing pool of investors. And soon
this becomes a self-reinforcing phenomenon; higher prices attract
greater numbers of investors that drive prices higher. Likewise
for bonds. Bond returns are rising because bond returns are rising.
Got it?

We have entered
the terminal phase of a bond bull market ushered in thirty years
ago by Paul Volcker, who drove interest rates over 20%. With 30-year
U.S. government paper now under 4%, the easy profits have been made
and the low-hanging fruit consumed. Investors today are shimmying
out on a very tall and thin branch in search of higher “total
return.” The snapping of the branch – sending investors
big losses – may not be imminent, but it is inevitable.

As we at Casey
Research have discussed and warned about often, the fiscal misadventures
of the U.S. government will have their consequences. And one of
the first victims will be bond investors as interest rates are forced
higher, much higher, to attract buyers, particularly foreign buyers.
When this happens, the total return on bond funds will be smashed.

The sad and
pathetic irony: to escape the beatings endured in the stock markets,
millions have sought safety in bonds. The punishment is not over.

We are afraid
an awful lot of investors will be left asking, “What was I
thinking?”

If you want
true protection from the ongoing economic turmoil, investing in
precious metals and major precious metal stocks is the way to go.
Even in the Great Depression, those who held physical gold and large-cap
gold stocks like Homestake Mining gained… while most other
investors lost everything they had. Read
here
why those investments will become even more valuable in
the near future.

David Galland
is the managing editor of Casey
Research
.

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