The Feeding Frenzy in Fixed Income

More than a decade ago, investors speculated wildly in dot-com stocks. You don’t need me to remind you how that ended.

Then a half-decade ago, investors went hog wild in real estate. That didn’t work out so well, either.

Now there’s another feeding frenzy going on. It’s not quite as visible as when you had speculators lined up outside of subdivision sales offices in the middle of the Phoenix desert. But it sure as heck is happening.

I’m talking about the feeding frenzy in fixed income.

Bond Funds Hoovering Up Cash
as Stocks Stagnate

How much money is chasing fixed income investments? Let me share some startling numbers with you …

• In the month of July, a net $10.4 billion flowed out of equity mutual funds, according to the Investment Company Institute. We saw those outflows despite a sizable rally in the markets, one that drove the Dow up by more than a thousand points.

Taxable bond funds, meanwhile, saw net INFLOWS of $26.2 billion. That’s more than $845 million a day!

• Was this a short-term trend? Some kind of anomaly? Not in the least! Year-to-date, equity funds have seen net outflows of $1.7 billion … while bond funds have absorbed a whopping $162.6 billion in net new cash.
• But here’s the real shocker: In the two years through this June, investors dumped a massive $480 billion into bond funds. That’s just shy of the $497 billion they poured into stock funds in 1999 and 2000 … right before the dot com bubble burst and stocks imploded!

The chart below shows just how divergent fund flows have been — and how persistent they’ve been, through stock market rallies and stock market sell offs.

Fed’s “War on Savings”
Forcing Investors’ Hands

Some of the inflows stem from simple performance chasing. Just like they chased dot-com stocks … then real estate … investors are flocking to fixed income because it’s “working.”

In fact, the average high yield (or “junk”) bond fund has returned 7.9 percent year-to-date, according to Morningstar. That compares to 0.15 percent for the average domestic stock fund.

But the big story, as I see it, is that the Federal Reserve is waging an undeclared “War on Savings.”

Fed policymakers like to highlight the fact that low rates keep mortgages and corporate loans cheap. But those same low rates are also decimating the portfolios of millions of savers who rely on coupon payments to cover living expenses.

I mean, the average 1-year certificate of deposit yields just 1.25 percent according to Bankrate.com, while the average bank money market account yields just 0.8 percent. Five-year CDs yield only 2.5 percent, while benchmark corporate bond ETFs like the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) are yielding around 4 percent.

What’s happening as a result?

The Fed’s low-interest rate policy has forced scores of retirees to take added risks to make ends meet.

Savers are being forced to stretch for yield. They’re buying longer and longer-term debt, from lousier and lousier borrowers. Or in investment terms, millions of investors are now shouldering rising levels of interest rate risk and credit risk, all thanks to the Fed.

The last time the Fed slashed rates to the bone and forced investors to stretch for yield, banks responded by creating all kinds of higher-yielding — but ultimately crappy — investments. Think CDOs, CLOs, and the like. Yet the Fed is at it again, prescribing the same medicine … and many investors are lapping it up.

I don’t think this is a bubble that will burst tomorrow, next week or even next month. But it’s definitely a developing trend to watch — and to be concerned about. We’ve already seen two investment frenzies end in disaster in the past decade, and there’s a real risk this one will too.

If you want to stay out of harm’s way, my prescription is simple: Don’t be a yield chaser. Avoid longer-term, higher-risk bonds.

Until next time,

Mike

---

© 2010 by Weiss Research, Inc. All rights reserved.

15430 Endeavour Drive, Jupiter, FL 33478