Strategic Insight on the Fed’s Quantitative Easing: Tricky News for Bond Fund Investors

The Federal Reserve’s recent news that it would use quantitative easing to bolster the slow-moving economy highlights – and will probably exacerbate – some concerns regarding bond mutual fund investors. Faced with a lethargic recovery, the Federal Reserve has responded with rock-bottom interest rates. This situation has created two closely related trends, both of which have sparked a flood of money into bonds and bond mutual funds.

First, as is common in a low-rate environment, bond mutual funds have logged impressive gains; the average investor in bond funds enjoyed 9.6% gains through the first 10 months of the year, following 18.6% gains for 2009. Such performance has drawn risk-averse investors into the general bond sector as a substitute for more-volatile equity funds. The second trend is that investors seeking current income have eschewed deposit accounts and money-market funds that are carrying near-zero yields; instead, they’ve shifted their money into higher-yielding short- and intermediate-term bond funds. Thus, bond funds have been seen as attractive alternatives to deposit accounts and money funds for income investors, and alternatives to equity funds for growth investors.

Although the rush to bond funds has been a global phenomenon, with over 60% of fund inflows in Europe and Asia going to bond funds, it has been most pronounced in the US. Over the first 10 months of the year, inflows into bond mutual funds (including ETFs) accounted for 80% of bond and stock fund inflows, according to Strategic Insight’s Simfund databases. To put this in perspective: until 2009 stock and bond fund flows together had never before topped $300 billion in one year, but in 2009 bond fund flows alone reached a record $400 billion, and this year bond funds will likely surpass $300 billion in flows.

Similar trends are buoying the bond market itself. This year is on pace to see around $6.5 trillion in bond issuance, according to data from the Securities Industry and Financial Markets Association. That would be the third-highest dollar value of issuance in history, close behind the $6.7 trillion issued in 2009 and also in 2003.

For much of this year, industry participants have worried that the flight to bonds has been overdone, and bond funds threatened to reach bubble proportions. Some fund management companies and broker-dealers have been trying to educate the public and at least push investors to diversify their bond holdings away from short- and intermediate-term bond mutual funds. Of particular concern is the many bond fund newcomers who don’t understand the risks inherent in bonds and view short- and intermediate-term bond funds as simply higher-yielding money market funds or alternatives to cash. These investors may be in for nasty surprises when interest rates eventually start to rise, causing bond values to fall.

Now, the Federal Reserve has essentially announced that it is seeking an ultra-low rate environment at least until June. Whatever else it may do, the quantitative easing will only reinforces the trends that have been driving massive flows of capital into bond funds, and extend these trends through the first half of 2011 (and possibly beyond). The ravenous demand for bond funds will continue for a while.

The downside is that this all may bring greater numbers of relatively inexperienced investors into bond funds, setting them up for disappointment when the economy strengthens and rates start to creep upward. The investment industry will certainly make more efforts to educate investors about bond fund risks. But given the history of investing, we expect that eventually many bond fund holders will face an unpleasant reckoning. When that – and the start of rate hikes—will come is anyone’s guess.

Strategic Insight, an Asset International company, is a leading research firm for the mutual fund and wealth management industry, providing clients with in-depth studies, consultation, and electronic decision support systems. Strategic Insight assists over 250 firms worldwide, including the largest U.S. mutual fund companies. Visit us at www.SIonline.com.