Bye-Bye Bonds?

August 5, 2010

Gentlemen prefer bonds. At least, until stocks do better, and then they prefer stocks. Until bonds do better, and then they prefer bonds again. 

Big money has been moving into bond funds over the last year or so. We saw a similar situation in the late 1990s, with massive flows into stock funds. Broadly speaking, this trend might lead us to favor stocks over bonds for the next few years, since we generally avoid whatever attracts fund investors. But there's a little more to this money flow than meets the eye.

Back in the late 1990s, investors poured approximately $20 billion a month, or a quarter trillion a year, into stock funds. Toward the end of the decade, Janus, the king of larger cap tech and growth stocks, was seeing nearly half of this new money, with very little new money going into bond funds. In fact, more money flooded into stocks in 2000 than into bonds during the entire 1990s. It was the decade of equities.

The end of the great bull run and dawn of a terrible decade for stocks took place in early 2000, the worst year to add new money to the stock market. Stock funds saw their biggest inflow year of all time at just over $300 billion – a record that has yet to be beaten, and, adjusting for inflation, may never be eclipsed. 

The 2000s were the decade of bonds. It's too bad that ten years ago, a popular investment "truth" advised us, "Stocks always beat bonds over long periods of time." 

During the past ten years ending in June 2010, Vanguard Total Stock Index (VTSMX) was down 0.82% per year on average, while Vanguard Total Bond Market Index (VBMFX) averaged a 6.2% per year return. The S&P 500 was down even more – 1.67% per year, as larger cap stocks underperformed smaller cap stocks. Don’t even ask about tech stocks…

Yet according to the ICI, fund investors really only started pilling into bond funds last year, adding a record $376 billion. 2007 was a pretty big year for bond fund inflows, but over the past two decades , 2002 was the biggest, with 141 billion coming in – near the bottom of the stock market, and during a pretty good time to favor stocks. 2002 was also the last calendar year of stock fund outflows, outside of 2008’s massive liquidation of a quarter trillion.

All this action would seem to indicate this is a great time to buy stocks, and a terrible time to buy bonds. This is becoming a pretty common theory touted by investment experts – even bond fund managers, but fund investors are still tepid on stock funds and favoring bond funds.

The future for bonds looks so bleak, in fact, that the great bond house PIMCO, manager of the largest fund in the world, the Total Return Fund (boasting a quarter of a trillion dollars in assets), is launching more stock funds, although mostly foreign stock funds. In investment circles, this is called hedging your bets. PIMCO doesn’t want to be the next Janus – riding high, and then losing more than half their money in the ensuing crash of their area of expertise.

But before we all go 100% stocks, let’s consider a few things. Sure, bonds are much less likely to garner solid future returns than they did in 2000, when yields were higher, and stocks are much cheaper than they were in 2000. But are stocks guaranteed to kill bonds like bonds were positioned to kill stocks in 2000? No. 

Unlike the late 1990s flow to stock funds, most of the "new" money going into bond funds was in CDs or money market funds: money that grew tired of 0%-1% yields, and no longer demanded FDIC protection. Back in 2008, over a trillion fled to the safety of CDs and money market funds (which had to be backed by the government during the crisis after one money fund had a problem with Lehman debt causing a run). 

CDs and money market funds are a type of very short-term bond fund. CDs have the extra guarantee of FDIC insurance, but a money market holding nothing but treasury bonds has a similar risk profile. This new money is not coming out wholesale from stocks and going into bonds. This is a bond-to-bond transfer, from zero-risk, very, very short-term bonds, to slightly risky short-to-intermediate-term bonds. 

It’s not even a big move to junk bonds or longer-term bond funds. Most of the largest junk bond funds haven’t seen assets grow much faster than returns, so a fund like Vanguard High Yield Corporate (VWEHX), now tipping the scales at $11.6 billion in both classes, has only seen assets go up about 22% over the last year, about the same as the 20% return in the fund. Long-term bond funds have seen minimal inflows, because investors are still fearful of interest rates going up and killing long-term bond returns.

The stock bubble was money going into a high-risk asset from something low-to-no-risk. Although there was a shift from value to growth, it was largely net new money to equities. This is shifting around the bond market.

If the Fed raises rates so you could earn 3% on money market funds or short-term CDs, you’ll likely see massive flows of money out of bond funds (perhaps even stock funds) and back into the higher safety of CDs and money markets.

Stock funds still represent most investors' long-term money. The typical retirement account, IRA or 401(k), has more money in stock funds than its combined total of bond, money market, and balanced funds (stock and bond mix). That's hardly the beginning of a great bull market in stocks and a terrible decade in bonds. 

A contrarian total portfolio (bonds and stocks) today would have a higher stock allocation, and a lower bond allocation than it did in 2000, but this is by no means the load-up-the-truck opportunity of a lifetime. It's possible both stocks and bonds could perform badly in the future. Rising rates and slow economic growth could cause it, as could deflation, which could impact non-government bonds as companies struggle to make high fixed payments on a deflating revenue base.

Fund investors were being irrational in the late 1990s passing on  a safe 5% yield only to move into a risky asset class despite signs of froth and high valuations. Moving into shorter-term, investment grade bond funds when money markets are yielding zero is not the most irrational choice in the history of fund investors. If we return to 3-5% money markets, and they still run to bond funds, or they start departing stock funds again, then we’ll talk about avoiding all bond funds completely.