According to the Investment Company Institute, investors pulled a staggering 33.12 Billion dollars out of mutual funds in the month of July 2010. The bulk of this money went into bonds, or bond mutual funds where the returns have been quite good for the past decade. Compare the good performance from bonds over the past ten years to what investors would have witnessed in the equities markets over the same period: two crashes, years of negative returns (on domestic equities for sure) as well as current economic prospects which are just shy of being dismal.
But are bonds the right place to invest? There are several very relevant and important arguments against investing in bonds at this point in time. They are as follows:
1. Bond rates, as well as every other type of rate, are expected to climb in the coming years. A quick look at the yield curve, or the difference between the three month and thirty year bond rates tells an interest story, one that the media has not been all that keen to write about. That story is this: we are heading into a period of economic expansion. If the yield curve was able to warn us about the economic recession we just survived, as well as those recessions over the past fifty or so years, why would it lie to us now? With an economic expansion, bond rates will rise and with rising rates comes downward pricing pressure on bonds. But more importantly, periods of economic expansion favor equities, the very asset class that investors are fleeing from.
2. Bond rates have nowhere to go but up. Considering that the yield on a 12-month bond is just 0.23% and an equally painful 1.4% on a 5-year government bond, what does intuition tell us about where those rates are headed? Of course, there is some downward potential. For example, the 3-month treasury is at 0.15%, so there is a bit more room. But when one investigates rates over the past decade, one will easily find that bond rates have been on the decline and over the past several years those rates have stabilized at current lows, crossing over key technical indicators (such as moving averages). This warns of a reversal in rates, which is bad news for bond rates, regardless of what will happen with stocks.
3. Chasing popular money is a lot like chasing bubbles. The current flee into bonds is extremely similar to where investors placed their money when oil reached for 0, when gold passed the ,200/oz. threshold, when people started investing in real estate without regard for rate resets, and so on. This is the first place to suggest that the next "bubble" could be the bond bubble.
While bond represent reasonable investments -- they are recommended as part of every long-term portfolio -- making sure that your asset mix is in line and that you are not over-exposed to bonds is an activity that will have pleasing long-term results in your portfolio. While bonds have a good history at this time, the trend may soon end, making bonds a riskier prospect than the equities that have not performed over the past decade.
