Investors are selling stocks and buying bonds. That might seem odd given that bond returns have been anemic, at best, while stocks keep chugging along, hitting record highs.
Nonetheless, investors can’t seem to get enough of bonds. Taxable fixed-income mutual funds and exchange-traded funds have raked in $166 billion in net inflows this year, including more than $6.1 billion in the week that ended Aug. 8, according to the Investment Company Institute. Bond funds and ETF assets now total $4.7 trillion, with ETFs accounting for 12.5% of the total bond-fund market, according to Bond Fund Intelligence, an industry newsletter.
Bond funds may be benefiting from an exodus out of stocks that has been building for months. Domestic equity funds have seen net withdrawals of $87 billion this year and $192 billion overall since January 2016, according to ICI data. Taxable bond funds, meanwhile, have recorded net inflows of $706 billion since then, while muni funds have raked in $75 billion.
Why the ardor for bonds over stocks? Investors may be taking profits, figuring the bull market, more than nine years old, has largely run its course. Although stocks have been moving higher, volatility has picked up, too, with crises flaring over global trade and instability in emerging markets lately. Earnings growth may also have peaked. And markets tend to be weak after that happens, according to RBC Capital Markets, which has urged investors to be cautious.
Yet bonds are under their own pressures, as rising interest rates drag on prices across the board. The Bloomberg Barclays U.S. Aggregate Index is down 0.9% this year, including interest payments. Globally, investment-grade bonds are on track for a -4.5% annualized return, according to Bank of America Merrill Lynch. U.S. Treasurys are on pace for a -2.5% return, and high-yield junk bonds are on course for a -0.3% return. Compare that to the S&P 500 (.SPX)—up 7.5% this year—and bonds look like dead money, at best.
One factor that may be making bonds more palatable is that yields have crept up to compelling levels, says Peter Crane, president of Crane Data and publisher of Bond Fund Intelligence. With rising rates hitting long-term bonds the hardest, much of the inflows are into ultrashort and short-term funds, he says. Assets in the largest ultra-short-term funds have hit $262 billion, up from $246 billion at the end of 2016. The average ultrashort fund now yields 2.2%, while short-term funds yield 2.7%.
Investors can scoop up yields above 3% in a few high-quality funds. Vanguard Short-Term Corporate Bond Index Fund ETF (VCSH) has a 30-day yield of 3.4%, for instance, lifted in part by a rock-bottom expense ratio of 0.07%. The iShares 0-5 Year Investment Grade Corporate Bond ETF (SLQD) yields 3.2% while iShares Ultra Short-Term Bond ETF (ICSH) yields 2.5%. Among mutual funds, Vanguard Short-Term Investment Grade (VFSTX) yields 3.1%, well above the category average. It has an expense ratio of 0.20%.
Investors shouldn’t confuse a fund’s 30-day yield with total returns, including gains or losses in the share price. Rising rates are pressuring funds’ underlying bonds, and their share prices are taking a hit as a result. All are beating the Bloomberg Barclays US Aggregate Bond Index, a benchmark known as the Agg. But only ICSH is up by more than 1%, after accounting for interest payments and declines in share prices.
Assuming rates don’t rise much further, however, the funds are likely to deliver positive returns over the next 12 months. Investors may finally reap some rewards for funneling so much money into bonds, which may help with the buyers’ remorse.
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