Don’t look now fans, but there is a new bubble brewing in the investment world. However, the bubble may not be billowing where you might expect. With the stock market having run 62% in six months and valuations quickly becoming a little rich, many investors are worried about a big decline in stocks. And while a meaningful correction in equities is becoming more likely with each passing month, the stock market may not be the big problem going forward.

What if I told you about an investment that has seen money been pouring in at a record rate lately? What if I told you that in this particular investment arena, new money is coming in so quickly that mutual fund managers literally can’t get the money invested fast enough? And what if I told you that there is almost a 100% chance that the driver of this particular market would turn negative in the not-too distant future? Would you be worried?

Well, you should be. And we’re not talking about U.S. small caps, technology, gold, oil, or even the emerging markets. No, we’re talking about the bond market. And more specifically, the public’s misperception of how bond funds work.

The “Flight to Safety” Trade

The last time the stock market got tagged for big losses during the 2000–02 “Tech Bubble Bear, the public quickly became fed up with the red ink in their growth stock funds and switched to what their financial planners were telling them was the relative safety of bond funds. Money poured into bond funds of all shapes and sizes because financial advisors, brokers, and the like had plenty of empirical proof (i.e. academic studies) that showed bonds were safer than stocks.

Up to that point and according to data from the Investment Company Institute, the highest net inflows (inflows minus outflows) in bond funds during a single month had been something on the order of $12 billion in early 1987. But surprisingly, the big inflow into bond funds came BEFORE the Crash of ’87. Instead of the buildup in bonds being a “flight to safety,” investors at that time were actually chasing returns as this was the heyday of the junk bond market. And we all know how that turned out.

Prior to the 1985-87 period, the records show that the high water mark for net inflows into bond funds on a monthly basis had been less than $1 billion. And after the demise of the junk bond market, bond funds actually saw consistent net outflows until the first Gulf War sent stock investors scurrying for cover.

It wasn’t until the mid 1990’s that the public learned to love bonds when things got scary in the equities market. Thus, we saw a big net build in bond funds from 1991 through 1993 and then again after the LTCM/emerging markets crisis in 1998. But the bottom line is that neither of these “flight to safety” periods caused bond fund inflows to exceed the $12 billion level seen in 1987.

Now fast-forward to the Tech Bubble Bear in stocks. Investors ran for cover in 2001, causing bond fund assets to soar as net inflows exceeded $17 billion by the middle of the year. And as the bear market in stocks continued to grow in intensity, so too did the flight to the safety in bonds. By the middle of 2002, net inflows had soared to nearly $30 billion.

Which brings us to the present situation. In looking at the chart of net inflows into bond funds, it is VERY clear that investors are once again in love with the concept of relative safety. In March, net inflows exceeded $20 billion for the month. April saw $28.7 billion, May: a record $30.6 billion, June: $27.5 billion, July: another new record of $32.5 billion. And then in August, which is the last month for which we have data, net inflows set another record at $38.6 billion!

The point here is that the public is throwing money into bond funds hand over fist. This is due to the facts that (1) they perceive bonds to be safer than stocks, (2) they’ve figured out that they should diversify their 401(k) plans, and (3) the money market fund and savings account rates are barely positive these days.

From an anecdotal point of view, I received a couple of calls recently from clients wanting to know why I don’t have the portion of our portfolios that is currently in cash invested something besides a money market account, which is yielding next to nothing. One woman suggested that I move to a bond fund because, “it’s just like a money market, but the yield is so much higher!”

On that note, we should point out that Charles Schwab was sued last week by a group of investors claiming that they had been sold bond funds as being similar to money market funds. And what happened last year during the credit crisis? Yep, you guessed it; the bond funds fell in value – and not by in inconsequential amount.

The Fly in the Ointment

There are a couple of problems with the public’s view that bond funds are a safe play right now. First is what we call the “structural” issue. In five of the last six months, bond fund managers have not been able to “spend” the cash that has been flooding into their funds. Think about that for a moment. While it sounds implausible, the demand for bond funds might actually be exceeding the supply of new bonds available for purchase. Can you say “too many dollars chasing too few goods?” And am I the only one with the term “overvaluation” suddenly screaming into my mind?

Another point on the structural issues relating to bond funds is the fact that fund managers buy and sell the bonds on a daily basis to adjust for the flow of cash in and out of the fund. A big thing to remember is that this affects the NAV of the bond fund. In other words, those investors thinking that they can’t lose money in a bond fund clearly do not understand the way these instruments work.

We are not arguing that owning a bond is a safe play due to the fact that the issuer will retire the bond in full upon the expiration date. Therefore, as long as the issuer can make the payment when the bond comes due, you won’t lose your principal. And after the two massive bear markets we’ve seen in stocks this decade, we certainly “get it” in terms of the public’s desire for safety.

But the problem is when investors put money into a bond fund – as opposed to buying a bond directly – they are not actually holding a bond until maturity. It is more like putting the money into the bond market indices. Thus, the buying and selling done by the manager as well as the movement in the bond market means that the fund CAN fall in value during a bearish environment for bonds.

Speaking of Bearish Environments

The second big fly in the ointment for those expecting to see a nice steady return on their bond fund investment has to do with the big-picture environment for bonds. In case you slept through that Econ 101 class years ago, remember that when the economy improves, interest rates tend to rise. And when interest rates rise, the value of existing bonds (that were issued at lower rates) goes down. And when this happens, the NAV of a bond fund falls as well.

Thus, from a very simplistic standpoint, the absolute worst time to invest in the bond market is when the economy is improving and interest rates are likely to rise. And where are we now from an economic standpoint? Oh, that’s right, we’re seeing an economy that is movin’ on up.

In the last couple of months, it has become very clear that the longest recession in a generation finally ended. And just last week, we heard Ben Bernanke tell us that the economies of China and the like in Asia are “recovering strongly.” This has led most economists to expect to see our economy continue to improve in the coming months.

Next up, we have the situation with the Fed. Just last weekend, the cover of Barron’s basically pleaded with Ben Bernanke to raise rates. And with the current FOMC target for Fed Funds sitting at 0% to 0.25%, it is pretty clear that there is nowhere to go but up. In English, this means that the Fed WILL be raising interest rates at some point in the future, it’s just a question of when.

So, let’s add up what we’ve got here. We’ve got the public throwing money at bond funds at such a rate that the managers can’t spend it fast enough. We’ve got a global economy that is improving rapidly. We’ve got the U.S. economy starting to move forward. We’ve got interest rates artificially set at a generational low. We’ve got a Fed that WILL raise rates at some point in the future. We’ve got a chance that we’ll see some inflation in the future, which of course, causes higher interest rates. And finally, we’ve got bond funds that tend to lose money when rates rise.

So, does moving money in your 401(K) plan over to bond funds STILL sound like a good idea to you? If your answer is no, give yourself a gold star. We can’t say when bonds will start to fall in value. And we may be VERY early with our concerns as the “too many dollars chasing too few goods” situation can keep this balloon elevated for quite some time (think tech stocks in 1999). But we can say that at some point in the future, bonds in general and bond funds in particular are NOT going to be the place to be as this is becoming one VERY crowded trade.

Wishing you all the best for a profitable week ahead,

David D. Moenning
Founder TopStockPortfolios.com

Positions in Stocks Mentioned: None

 

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