It's coming, so they say. Flows will begin to rise and crescendo like a tidal wave, too powerful to ignore. Those too stubborn and unyielding to heed the signs of this sea change will be among the wreckage, with little recourse in its devastating wake. After years of warnings without validation, too many will be unprepared and the scale of destruction will be unprecedented.
No, this is not a warning of a hurricane or some other natural disaster, or the end of the world in any traditional sense. This is about the much-prophesized impending apocalypse for investors in fixed income, which, if you believe the hype, is nigh.
Proponents of this theory of an impending massive reallocation from bonds to stocks have some serious egg on their face, for these predictions have been made in each of the last three years. Instead, equity funds have continued to see outflows, while bond funds have set new records in their asset grab. Indeed, according to the Investment Company Institute (ICI), since January 2009 taxable bond funds have been the beneficiary of more than $850 billion in fund flows and municipal bond funds another $100 billion. During that same time, some $1.4 trillion has left both U.S. stock and money-market mutual funds.
This year could be different, though as the calendar turns to the final quarter of 2012 not much has changed. Although U.S. stock market returns this year have been compelling, with the S&P 500 up over 11% year to date as of this writing, equity fund flows continue to stagnate, and were down almost $70 billion through mid-August. Bond funds have done well in their record low yields, with the Lipper Intermediate Investment Grade Debt Funds peer group gaining 5.9% and the Lipper Intermediate Municipal Debt Funds peer group up 4.0% through July 2012. But these returns are all the more impressive given the staggering $200 billion in assets added to bond funds this year, according to ICI's asset tracking.
With such a massive disparity of flows, the notion of an impending reallocation out of bonds and into equities may not be so far-fetched. After all, our domestic economic growth appears to be muddling through, and while growth is subpar at or below 2%, the threat of another recession is low. The consumer has deleveraged-household debt as a percent of GDP has dropped down to historic trend levels, while household debt as a percent of disposable income is at a five-year low of 110%. Debt service and financial obligations ratios have improved. Employment is slowly recovering, and the U.S. housing market has stabilized in price and turnover.
Furthermore, inflation remains moderate, and other risks to the financial markets-such as the European debt problems or a meltdown in China-seem to be resolving either through policy action or the expectation of it, and that has induced a relative calm, at least for now. Even discussion of the U.S. fiscal cliff seems somewhat surreal, with most investors anticipating some measure of resolution to the simultaneous spending cuts and tax increases set to occur at year-end.
Most compelling of all, valuations in equities look attractive relative to historical standards, with the market's forward P/E estimate just 13.7 in the United States, and even less abroad, while bond interest rates are at historically low levels that offer inferior income to savers and investors unless the riskiest type of debt is considered.
So why then do we continue to see surging investor demand for bonds and what are the prospects for a shift away from bonds into stocks?
Pervasive fear is probably the single most important driver of demand for bonds, with investors still reeling not just from the losses sustained in the market bust of 2008, but from a lost 13 years of investment returns (since 1998). Not helping matters is the 35% drop nationwide in home prices, as well as the continued tax, economic, political and employment uncertainty. Adding to the fear parade are the flash crash of May 2010, whose origin is still unknown, and a botched Facebook IPO, as well as increased volatility created by high-frequency trading strategies and leveraged ETFs. More recently, Libor-gate has erupted, a scandal involving the world's largest banks that apparently falsely deflated the London Interbank Offered Rate (Libor) for their profit during the height of the financial market crisis in 2008.
Even absent these unsettling events, the appetite for risk-taking seems to be in a kind of secular decline. With the baby boom generation reaching retirement age, the impulse to de-risk is high, and these demographics may make lower risk appetites a longer-term phenomenon. Just as that same generation drove a massive market-centered bubble in the second half of the 1990s, in which equities reached new and ultimately unsustainable highs, today they are operating in reverse, forcing bond yields to record lows. As for whether the stock market's good fortunes in 2012 might lure them back into equities, the jury is still out, but it is not looking good. Between greed and fear, fear may be the more dominant emotion. For many of these investors, a return of principal is more important these days than a return on principal.
Further aiding investors' comfort level in being overweight in fixed income has been the Federal Reserve, whose loose monetary policies and market interventions have worked to induce a kind of "Permanent Bond State" where the traditional risks of fixed-income investing have ceased to exist. The Fed may have the power to keep investors irrevocably allocated to bonds for the indefinite future with its commitment to low interest rates until at least late 2014, an ongoing Operation Twist, to keep long-term bond yields low, and the start of QE3. With the risk of rising bond yields eroding principal ostensibly off the table thanks to the Fed, bond investors' biggest problem these days seems to be finding bonds and stomaching the low yields.
Ironically, expectations about inflation have provided another boost to bonds even as yields have declined. Just as high inflation erodes the purchasing power of bonds' fixed payments over time, persistent low inflation makes future payouts all the more valuable. Remarkably, as a result of the disinflation inherent in the slow-growing U.S. economy today, the "real" yields on bonds-the amount they pay above inflation-is actually increasing, making buying and holding bonds an attractive proposition, at least as long as the U.S. economy is expected to be in the doldrums.
Admittedly, fear and the Fed may not be able to hold investors back from equities forever. Indeed, it may be subpar bond returns themselves that spark a reallocation from the asset class. After all, expecting bonds to perform as well in the future as they have over the past 30 years is unrealistic. With bond yields at record lows, the mathematics of total return simply won't allow it. Further, rising interest rates and inflation may not be as easily controlled as the Fed would have us believe.
After all, the Federal Reserve's swollen balance sheet and long-term commitment to low interest rates may be appropriate for the current low-growth environment, but should the economy advance to a more normal state or the rest of the world improve its condition enough to put the spotlight back on the U.S. and our unsustainable debt policies, the Fed's interventions would be difficult to roll back fast enough to avoid the spark of inflation. Some conspiracy theorists even argue that the Fed is comfortable with inflation running higher than bond yields, using financial repression as a back-door method of lowering our national debt.
For this reason, investors in bonds must be careful to consider the kind of fixed-income investments they are purchasing and be more focused on total return than yield in their portfolio management. The most interest-rate-sensitive segments of the bond markets, such as U.S. Treasurys, will be the most exposed to a backup in yields or a spike in inflation, and those securities offer little compensation for those risks these days. Corporate and municipal debt offer some incremental yield advantage, but are still highly correlated to movements in general market interest rates and vulnerable to the sting of inflation. Less correlated are sectors like high-yield debt, international and emerging-market bonds, convertible securities and preferred stock, though they introduce equity-like risks to a portfolio that may not be attractive to a traditional fixed-income investor.
Ultimately, the best argument for investors is to avoid over-allocating to any asset class and to prudently blend a mix of bonds and equity in fulfillment of the central tenets of modern portfolio theory. Rather than focusing on one asset class to the exclusion of another, given emotions or naïve expectations of future performance, investors must return to the fundamentals of asset allocation and develop an intermediate to long-term framework of risk tolerance and financial objectives that supersedes all else. As advisors, we must guide our clients in this process, and be disciplined both in our initial implementation and ongoing practice management. After all, a so-called "Great Reallocation" from bonds to stocks is one kind of financial market apocalypse we can all live without.
Michelle Knight is chief economist and managing director of fixed income at Silver Bridge (www.silverbridgegroup.com), an independent wealth advisory and multi-family office boutique. All investment advisory services are provided by Silver Bridge Capital Management LLC, a registered investment advisor affiliated with Silver Bridge.