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By Christine Benz and Kevin McDevitt, CFA | 05-11-2012 10:00 AM

Do Fund Flows Show a Bond Bubble?

The $700 billion that has flowed into taxable-bond funds in the last five years is larger than flows into U.S. equity funds in the late '90s, but investors today seem to be reacting to fear and not chasing performance.

Christine Benz: Hi, I am Christine Benz for Morningstar. Ongoing flows into bond funds have sparked discussion over whether we are in the midst of a bond bubble. Joining me to discuss that question is Kevin McDevitt. He is editorial director with Morningstar. Kevin, thank you so much for joining me.

Kevin McDevitt: Thanks for having me, Christine.

Benz: Kevin, let's start with this question. You recently took a look at inflows into bond funds and you compared them with the last big market-centered bubble that we had back in the second half of the 1990s. Let's talk about what you found. How does the magnitude of fund flows compare with what we experienced back then?

McDevitt: The biggest surprise for me was that in absolute terms, what we're seeing in terms of flows into bond funds today versus those that we saw into equity funds in the late '90s, flows today vastly outstrip what we saw in the 1990s. That's true in absolute terms, but also in relative terms. 

So, just for starters, in the last five years or so, you've seen over $700 billion go into taxable-bond funds, and in the late' 90s, you saw about $650 billion go into U.S. equity funds. So in absolute terms there you do see a greater flow into taxable-bond funds. But also if you look at it on a year-by-year basis to see relative to the asset basis, relative to beginning assets, how flows are compared, again you've seen a greater percentage of flows go into taxable-bond funds than you had with equity funds in the late '90s.

Benz: So one thing you noted in the report, Kevin, though was that this doesn't appear to be necessarily performance-chasing, it's more that investors may simply be derisking their portfolios as they get closer to retirement, and also perhaps fear is it's still hanging over market participants in the wake of the bear market.

McDevitt: Right, in the late '90s, it definitely seemed to be more about greed rather than fear, and today perhaps that's reversed. Fear may be the more dominant emotion. I think what we worry about, we may get to this next, is that it doesn't necessarily mean there will be a better outcome for investors given that they're reacting out of fear rather than greed, but maybe more than a second.

I think as you pointed out this time around it's been more investors pulling money out of equity funds, perhaps they cut risk in their portfolios, while also pulling money from money markets funds and shifting that money into bond funds, perhaps looking for greater yield than they're getting on money market accounts which are essentially close to zero at this point.

Again, mentioning before that we've had over $700 billion go into taxable-bond funds, during that same time--just since January of 2009--we had over $700 billion go into taxable-bond funds. During that same timeframe, you've had $1.4 trillion leave both U.S. stock funds and money market funds. So it's not necessarily that you are seeing new contributions, new money going into taxable-bond funds, money has been pulled from other areas. Again that's a real contrast versus what we saw in the '90s, where there wasn't necessarily money being pulled from bond funds or money market funds to go into equity. These were new contributions. One point we make in the report is you actually saw a similar level of contributions going into money market funds, more than $600 billion from '95 to 2000, as you saw go into equity funds. You had about $650 billion go into equity, and I believe about $630 billion go into money market funds.

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