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By Jeremy Glaser and Michael Rawson, CFA | 01-11-2013 09:00 AM

Future Return Potential for Bonds Lacking

After heavy flows into fixed income in 2012, investors likely won't see strong capital appreciation in bonds in 2013, says Morningstar's Mike Rawson.

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Jeremy Glaser: For Morningstar, I am Jeremy Glaser. I'm joined today by Mike Rawson. He is a fund analyst at Morningstar. We are going to look at the 2012 fund flows.

Mike, thanks for joining me today.

Mike Rawson: Thanks for having me Jeremy.

Glaser: So, 2012 was a pretty strong year. We had $435 billion of flows into open-end funds and exchange-traded funds, but fixed income, again, was a big part of that. Can you talk about the flows into bond funds, and why investors are looking there?

Rawson: Sure. So, as you mentioned, flows in general were strong, but they were particularly strong in fixed income. Again, it's really kind of surprising because we saw strong flows into fixed income in the 2009 time frame. People were just coming out of the financial crisis. So, people were kind of anxious about putting money into stocks. It was rational that they would go to fixed income. But just over the past couple of years, flows into fixed income have actually picked up and increased despite the fact that the equity market looks relatively attractive.

So, within fixed income what was new this year is that we saw really strong flows into the higher-risk segments of the fixed-income market. Areas such as emerging-markets bonds, high-yield bonds, and multisector bonds all had really strong flows. Bank loans is another category. And people were also willing to take more duration risk. So, they were going into longer-term bonds. So there was a little bit of a change, a little bit more aggressiveness on the part of fixed-income investors.

Glaser: But is taking that risk on the fixed-income side a sensible strategy? Is that something investors are going to be rewarded for?

Rawson: Well, certainly they were rewarded for taking the risk last year. High-yield funds returned on average around 15%, so those were strong returns last year. However, going forward I don't think we are likely to see the kind of price or capital appreciation we saw last year. So, if you're in those fixed income areas, you're more likely to get a return which is closer to the yields, a coupon type of a return, rather than the strong capital appreciation we've seen in the past.

I think going forward it's likely in 2013 to see stronger flows in equities just because the return potential in fixed income just isn’t there. Now, of course, fixed income always has a role on your portfolio as a way to kind of hedge against risk in terms of the equity market. So, it provides some stability to your portfolio, but I don't think you're going to see the kind of price appreciation in the riskier segments of the bond market you saw last year, particularly because the yield curve has already come down so sharply.

Glaser: Let's talk a little bit about equities then. The S&P 500 was up 16% in 2012, yet investors continued to kind of shun that space. What’s going on there?

Rawson: So, the equity market, as you mentioned, was strong. The S&P 500 was up 16%. Again, investors really don't want to take much equity risk. The only two bright spots I think in equities were either international in terms of emerging markets; we saw a strong flows into emerging markets. And we saw strong flows into passive investment vehicles again. So, ETFs and index funds saw strong flows. In fact, it was a pretty sharp divergence, people selling actively managed funds and going into index funds.

Once again, though, I think 2013 will probably be a better year for flows into equity products. And just because investors have been kind of shunning equity in terms of adding new money to the market, it doesn't mean that they’ve abandoned equities in total because the equity market has been growing. Investors still have a large percent of their assets in equities. As the equity market has appreciated, the tide has lifted their allocation to equities. So, on the margin, investors are avoiding equities with new flows, but they still have a significant portion of their assets in equities.

One of the things which I think is most interesting if you look back over the last 10 years is that there's been a sharp divergence, where 10 years ago U.S. stock equity assets were about 50% of an investor’s portfolio, and that's come down sharply, to the point where now fixed-income assets are a greater proportion of the investor’s assets. So, I think in the future, if we were to see a rise in inflation, I think that could pose a big risk for investors because fixed-income assets generally don't hold up well against inflation, whereas, over the long-term, equity assets can kind of hold up better if there's a big spike in inflation.

Glaser: Mike, thanks very much for your thoughts today.

Rawson: Thanks, Jeremy.

Glaser: For Morningstar, I am Jeremy Glaser.

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