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By Christine Benz | 03-12-2012 02:00 PM

Investors' Love Affair With Bond Funds Continues in February

Investors keep plowing money into intermediate- and high-yield bond funds, but Morningstar's Kevin McDevitt thinks this strategy could end in disappointment.

Christine Benz: Hi. I am Christine Benz for Morningstar. In February, open-end mutual funds had one of their best months of inflows in two years. Here to shed some light on which categories investors have been gravitating to as well as what they've been shunning is Kevin McDevitt. He is editorial director for Morningstar. Kevin, thank you so much for joining me.

Kevin McDevitt: Thanks for having me, Christine.

Benz: Kevin, let's start with the headlines. Investors continued to pile into bond funds during the month of February, both municipal and taxable, but especially taxable. Which categories have investors been buying?

McDevitt: It's a similar story to the last few months, where intermediate-term bond funds and high-yield bond funds have seen the greatest flows. I believe we saw about $14 billion or so go into intermediate-term bond funds, and I believe about $5 billion or so went into high-yield funds.

Benz: You know, we're three years into this stock market rally. What are investors responding to in terms of being attracted to bonds at this juncture, and not really being as attracted to stock funds?

McDevitt: I have a feeling they are responding more to what happened in 2011 than what's happened so far this year. Clearly, that's the case because, again, we saw some modest outflows out of U.S. stock funds; a little more than $1 billion went out of U.S. stock funds. That's perhaps somewhat surprising, considering that the S&P 500 is up about 9% or so this year.

So, I think again, in terms of the flows into bond funds, it's more reflective of what happened in 2011. You can perhaps actually could go much longer term than that and say, well, taxable bond funds in general have done better than equity funds have over the last decade or so. I think there's probably a short-term dynamic to it, again, looking at last year, and then also a longer-term dynamic, as well.

Benz: Kevin, with this ongoing flow into bond funds, it appears that investors are saying they'd rather settle for a low but knowable return than risk greater losses in stock funds.

McDevitt: I completely agree. I think that's very much a part of it. Certainly, the other trends we've talked about before, too, in terms of demographics, have had an effect, particularly just the aging of the baby boomers. They are perhaps less willing at this point to take on extra risk via equity funds just by looking at trailing returns. Then, as you mentioned, their experiences through the recent credit crisis as well as in the 2000-2002 bear market have been deterrents.

But one interesting point along those lines though, and one thing I find somewhat surprising, is the popularity of high-yield funds in regard to the credit crisis. In the credit crisis in 2008, the average high-yield fund lost more than 20%. Of course, that's better than what you saw from the average stock fund. The average large-blend fund, I believe, lost about 37% in 2008. So, certainly, investors did fare worse in equity funds in 2008. But since then, you've had strong returns out of high-yield funds, but they've been even stronger for equity funds. However, the difference is that you've had net outflows out of equity funds since the credit crisis, but high-yield assets have pretty much tripled since the credit crisis. I don't want to say it's selective memory on the part of investors, but it's curious to me how they've been very much willing to go back into high-yields funds but not into stock funds.

Benz: Maybe some good old-fashioned yield-chasing going on there?

McDevitt: Yes, that's a good point, right. With the yields so low, with the 10-year Treasury at 2.0% and the yield on the Barclays U.S. Aggregate Bond Index at about 3.2%, you're getting much better yields out of high-yield bond funds. Whether or not you'll see better returns long term is a different question, but at least in terms of where we are today, yields are certainly more attractive in that sense.

Benz: You wrote in your recent commentary on fund flows, Kevin, that you wondered if this love affair with bond funds that investors have been having could end in tears. Can you expound on that?

McDevitt: Sure. It really goes back to kind of where yields are today and what your prospective returns are going to be going forward. Again, you could go back up to three decades and say, we've been in this very long-term trend of declining interest rates and declining yields, and that's really been the fuel behind bond-fund returns. And starting from where we are today, it's going to be very hard to repeat that performance, if not really impossible, to see those kinds of gains driven by falling yields.

Now, that's not to say, you couldn't have a scenario in the U.S. as has happened in Japan. Japan had very low yields 10 years ago, and they've only gone lower. So actually, Japanese bonds, especially for Japanese investors, have not been that bad of a place to invest. That same scenario could potentially play out here, but there is a lot of risk involved there, especially with the fact that right now, U.S. inflation is running about 3%. So, if nothing else changes, if inflation rates stay where they are and yields stay about where they are, most bond-fund investors will get no real return out of their investments.

Benz: Right. Now, Kevin, switching gears to equity funds, you mentioned that there has been sort of a steady drip-drop or maybe an even bigger flow of outflows from equity funds, and that continued in the first couple of months of this year. But you noticed that it had slowed down a little bit.

McDevitt: It has slowed down. Again, maybe not as much as you might expect, given that the market is up about 9% or so, so far year to date. As you know, we're off to one of the best starts, I think, in about 14 or 15 years. So, it's not surprising that it slowed. What maybe is somewhat surprising is that investors have not returned in greater force to U.S. stock funds. But again, that's been the theme we've seen the last five or six years. When the market has rallied in recent years, investors have not really tended to come back to equity funds the way they did perhaps after the 2000-2002 bear market, when in the first half of the 2000s, you did see more investors coming back to the market.

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