The 2007-2009 global financial panic and collapse provided investors with a once in a lifetime rollercoaster ride as all asset classes except for treasury bonds dropped to extreme lows. A vast spectrum of emotions accompanied investors on this thrill-ride and not surprisingly many of these emotions are shaping investors’ current investment decisions.
In a search for safety and income, investors are stampeding into the apparent safety of government bonds and bond mutual funds. Over the last year, bonds have been purchased in record amounts despite historic low interest rate levels. It is likely that many of these investors do not understand the risks in bonds. These investors, with a false sense of security, are unknowingly setting themselves up for another rough rollercoaster ride ahead.
Warning Sign: High Level of Flows to Bond Funds
Despite the remarkable rally in stocks over the last nine months, the distrust in equity markets is still widespread. The cash flow figures into bond mutual funds this year illustrate this point (click on chart below) as almost $313 billion has been invested in bond funds compared to the $2 billion added to stock funds through October. In addition, insignificant yields on money market funds are testing investors’ patience and are yet another reason for the remarkable cash flow into bonds.
History shows that cash flows to mutual funds tend to follow strong outperformance by a particular asset class and can provide a contrarian warning sign when a particular class is becoming too popular.