Surge of money from bonds could stifle lending
NEW YORK – Americans are leaving bond mutual funds at the fastest rate in more than two years.
U.S. investors pulled $8.6 billion out of bond funds in the week ended Dec. 15, the largest withdrawal since October 2008 when financial markets were in free-fall. They pulled an average of almost $3 billion every week since Nov. 23, according to the Investment Company Institute. Prior to November, money had been flowing into bond funds every week for nearly two years.
"This is the real deal," says Marilyn Cohen, founder of Envision Capital Management, which oversees $300 million in mostly fixed-income investments.
If she's right, the end of cheap credit is near. Interest rates would rise, which would ripple through the economy. It would become more expensive for cities, states and companies to borrow money to build schools, roads and expand their businesses. It would also cause the value of bond funds to fall, blindsiding Americans who thought they'd stashed their retirement savings in an investment that wouldn't sink.
Bond funds are creditors. They take cash from savers and lend it to corporations and governments in exchange for interest payments and promises that the cash will be returned at a certain date. If there's less money to lend, borrowers need to pay higher rates to coax funds to buy their bonds.
It follows the law of supply and demand. If there's less of something, it pushes the price up. In this case, if the stream of money running into bond funds dries up, the cities, states and corporations that rely on them for financing will wind up paying more to borrow.
That would hurt cash-strapped states like California and Illinois which can't afford higher debt payments. It also means that Wal-Mart Stores Inc., Johnson & Johnson and other corporations will no longer be able to borrow money at the cheapest rates on record. IBM Corp. sold $1.5 billion worth of bonds in August at a rate of just 1 percent.
With few exceptions, Americans have favored U.S. stocks over bonds since the early 1990s. The housing bust broke that habit. U.S. stock funds began bleeding cash in 2007 and bond funds began piling it up.
That shift intensified during the financial crisis as people sought safer investments and bond funds began posting stronger returns. Banks and foreign governments made U.S. bonds a favored hiding spot during the financial crisis, knocking the yield on the 10-year Treasury note down to nearly 2 percent. The yield had been above 5 percent in June and July of 2007, before the onset of the Great Recession in December of that year.
The embrace of fixed-income funds throughout the recession had many benefits, says Hans Mikkelsen, credit strategist at Bank of America-Merrill Lynch. The record $376 billion that flowed into the bond market in 2009 allowed corporations to refinance their debt at cheaper rates. Without it, Mikkelsen says, many companies would have defaulted.
"It should have been the worst run of defaults we've ever seen, but instead it ended up being the shortest," Mikkelsen said.
Just as their safe and steady performance drew investors to bond funds, the recent rout in debt markets is scaring them away. In four of the past five weeks, Americans have yanked more money from bond funds than they invested, the only weeks this year that has happened.
Nicholas Colas, chief market strategist at BNY ConvergEx, regularly checks the data tracking investment flows for any surprises. Watching the slow, steady drip of cash into them became tedious after a while.
"Now it's like when you see a car crash," he says. "First you look and think, 'Did that really happen?' And then you check to see if everything is OK."
Even the world's largest mutual fund has lost some appeal. Pimco's $256 billion Total Return Fund, run by bond market guru Bill Gross, returned just 1 percent a month on average until November, according to Morningstar data. That month the bond fund lost 1.4 percent, its worst performance since September 2008. Investors pulled $1.9 billion from the fund in November, the first net withdrawal in two years.
What spurred the change? It started with a sharp drop in Treasury prices in mid-November, which drove long-term interest rates up from near-record lows. That sent borrowing costs higher across the board because all U.S. debt markets take their cue from the Treasury market.
Treasury prices had been climbing since late August on hopes that a major bond-buying program by the Federal Reserve would prevent long-term interest rates from rising. But then a number of economic reports started to raise hopes that the economy was strengthening. That led investors to start pulling money out of Treasurys.
The big blow came after President Barack Obama announced a compromise with Senate Republicans to extend tax cuts for two years and unemployment benefits for another year. Economists raised their forecasts for economic growth, and bond traders began bracing for even wider federal budget deficits. Both spell trouble for bonds. The tax package, signed into law last Friday, is expected to cost $858 billion.
"All that talk from Washington about wanting to keep budgets tight just went out the window," Colas said.
The real danger, analysts say, is if the selling starts to feed on itself, creating a steep jump in long-term interest rates. Investors ditch bonds, pressing prices down and causing more investors to flee. "Selling begets more selling," Cohen says. "The psychology of greed and fear never changes."
Under the worst-case scenario, long-term rates shoot higher and derail the recovery. If they rise gradually without choking off economic growth, some think the money flowing out of bond funds will find its way into stocks. That hasn't happened yet. U.S. stock funds are still seeing an average $2.3 billion in net withdrawals a week.
Stock funds have two important trends running in their favor.
— Stocks became less volatile right after the bond market started to weaken in November, and major indexes have been on a steady climb. Analysts say investors may wind up returning to stocks for many of the same reasons they piled into bonds: a sense of security and greed.
— Studies show people tend to follow winners. This "return chasing" benefited bond funds when they trounced stocks, and it may help lift stocks next year, Mikkelsen says. The Standard & Poor's 500 index has returned 15 percent including dividends over the past year and has notched two-year highs day after day this month. On Tuesday, it hit the level it traded at just before Lehman Brothers filed for bankruptcy in September 2008.