ON IT goes, defying all warnings of a bubble in the making and even a genteel correction: the investor love affair with bonds and bond market funds shows no sign of cooling.
A combination of depressing forecasts for the economy, worries over corporate earnings, market volatility and all-too fresh memories of the financial crisis and tumbling stock markets continue to keep investors in a cautious and equity-averse mood.
The eurozone debt crisis is still simmering, while in America investors fret over the “fiscal cliff” looming at the end of the year. For the best part of two years the market mood has switched nervously between “risk on” and “risk off”.
It is hard to argue against this reaction. With the International Monetary Fund downgrading its global growth forecasts again last week and equity markets vulnerable to swift and sudden reversals after each tentative advance, who could urge investors to moderate their blind faith in bonds?
Fixed income funds in August continued to outsell all other types for the 12th month in succession. According to the Investment Management Association (IMA), about a quarter of all investment went into this asset class. “Strategic” bond funds remained the most popular, with net retail sales during the month of £187 million. Close behind were corporate bond funds, which pulled in sales of £184m.
In sharp contrast, investment funds specialising in the UK All Companies sector suffered a net outflow of £401m, making it the worst-selling sector.
This was further testimony to the deep caution of today’s retail investor, because it followed a strong surge in global equity markets over the summer.
A similar pattern has been evident in America. So far this year, US investors have pumped $220 billion (£137bn) into bond funds, while cashing in $80bn of equity funds, according to the Investment Company Institute. In the four years since Lehman Brothers collapsed, US investors have poured $900bn into bond funds, while pulling out $410bn from equities.
And the bet on bonds has paid off handsomely till now. A typical bond fund is showing a 20 per cent gain over three years and a 40 per cent gain over five – tearing a big hole in the case for equities “over the longer term”.
No wonder Bill Gross, the money manager at Pacific Investment Management (Pimco), recently announced the death of the cult of equity. Mr Gross, one of Wall Street’s most-watched figures, said that investors were giving up on the siren song of the 1990s, when “stocks for the long run” was deemed a guaranteed ticket to wealth.
An investor today, he noted, “can periodically compare the return of stocks for the past ten, 20 and 30 years, and find that long-term Treasury bonds have been the higher returning and obviously ‘safer’ investment than a diversified portfolio of equities.”
Earlier this year, the noted US investor Wilbur Ross warned that “the greatest bubble that’s about to burst is the ten-year and longer Treasurys. Because the idea that inflation is gone forever and for all time – and therefore these artificially low rates can last – is silly.”
The fear is that before too long there will be an inflation surge as rounds of monetary easing work through to retail prices. In the years leading up to the financial crash, the private sector became a debt druggie. Now, says Ross, it’s government that’s become a debt druggie.
So far, the dire warnings of a bond market bust have not been borne out. The market continues to believe that interest rates will remain low and that bonds and fixed interest funds remain the safest place to be.
For generations the orthodox advice to investors seeking to reduce risk and ensure maximum capital protection has been to reduce exposure to shares and switch into fixed interest investments and/or government and corporate bonds. This has also been the standard advice to those approaching retirement. The nearer the date of crystallisation for the pension nest-egg, the greater the weighting towards fixed interest. The advice has been that your equity exposure should be 100 minus your age.
However, the normal rules are neither relevant nor applicable. Central bankers say that present previous policy prescriptions are no longer a guide and that we are in totally uncharted waters with rock bottom interest rates and repeated resort to quantitative easing or money printing to lift economies out of the doldrums.
The historic concern over resort to such a policy is that there would be an inflation consequence. There has been no sign of an inflation upsurge – thus far. But it would be foolish to invest on the basis that the risk of such an upsurge has been totally removed.
The best risk mitigation in today’s environment is asset diversification – spreading investments over equities, fixed interest, commodities, gold, property and bonds. A retirement portfolio over half of which is invested in bond funds would, in my view, be taking a big risk on the belief of the permanent conquest of inflation. So long has been the bond market run, I would favour a majority positioning away from bonds at this time.