Bond Funds: The Exodus Begins

After buying bond mutual funds in large quantities since 2006, U.S. investors started a convincing liquidation of their positions in November. It's not sudden, and not the popping of a bubble, but it's a strong suggestion of where the bond and stock markets may be headed for 2011.

The portfolio strategy group at Credit Suisse sends me its research on market trends, and yesterday's report was titled "Bond Buyers Bailing." I wouldn't call it bailing -- not yet -- but certainly "backing away" would be fitting and even makes an alliteration.

Bond funds are not an investment that individual investors simply buy and hold. In 1999 and 2000, when stocks were so strong, investors funded their purchases by selling a net $53 billion. (The purchases of stock funds at the time were about 10 times larger.)

During the subsequent collapse of stocks, investors bought $260 billion of bond funds in 2001 through 2003.

Things were quiet again until 2006. From then through year-end 2010, however, bond fund purchases were a net $820 billion, most of it packed into 2009 and 2010.

Following the economist's rule that it takes three data points to make a trend, Credit Suisse researcher Ana Avramovic writes:

At this point, outflows are a relative drop in the bucket. In the 22 months of inflows from Jan-09, every month added at least $15 billion, and 9 months recorded more than $30 billion. Total outflows over the past 3 months are $24 billion. But, the change in direction is significant.

Bonds are underperforming, says Ms. Avramovic, and cites three reasons investors might have in mind when they are selling. (She notes: "While these aren't necessarily new concerns, it seems that investors are finally coming to terms with the risks and exiting bond investments.")

One is potential inflation (see my post earlier this week). Second is that bond prices have been falling, for whatever reasons, and with yields too low to offset losses in principal, people are looking at stocks instead.

Third is the credit risk inherent in the U.S. economy these days (another topic this week). Credit risk is not just a vague notion: Japan lost its AAA bond rating yesterday, and the credit rating agency Moody's warned that a rating cut for the U.S. may not be far behind.

If you've put a lot into bond funds, it's worth refreshing your acquaintance with just what you own, and understanding how sensitive the fund share prices would be to a rise in interest rates -- say, one percent. (Check the funds' duration: the bond market rule of thumb is that for everyone one rise in rates by one point, prices will fall by that times the duration.)

If investors start to liquidate their bonds in a convincing way, there will be a lot of selling pressure on the bonds that have served us so well.