Why Another Bond Surprise?
Investors are putting their money into bonds again, confounding experts who have long expected them to continue switching into riskier assets such as stocks. To understand why, it helps to assess who those investors are and how they think.
Not long ago, the script seemed straightforward. Having surged in the midst of the “flight to quality” triggered by the 2008 global financial crisis and the recession that followed, the prices of U.S. Treasury bonds were supposed to fall -- aided and abetted by an economic recovery, less policy accommodation on the part of the Federal Reserve and the exhaustion of the European debt crisis. This would push up the bonds' yields, which serve as the foundation for interest rates on everything from mortgages to corporate bonds.
The trend was supposed to prompt investors to pull large chunks of money out of bond funds, fueling a “great rotation” in asset allocation that would favor equities in particular. This rotation would be large and prolonged, given the extent to which retail investors had shied away from the stock market after the 2008 debacle and, instead, poured into bonds.
So far, investors have failed to follow the script. U.S. Treasury yields fell this month to levels not seen since October, before closing last week at 2.53 percent for the benchmark 10-year bond, about 0.5 percentage point lower than the start of the year. Meanwhile, bond funds registered their 11th consecutive week of inflows that, remarkably, included a one-week $3 billion infusion into long-term Treasury funds, a segment that was deemed particularly vulnerable to losses.
Rather than exit at higher prices and reap the gains their bond holdings have already achieved, investors are buying. Even those outflows that occurred before the great rotation petered out this year were muted by considerable re-allocations within fixed income away from government securities and into corporates and bank loans. Instead of abandoning the asset class completely, many investors chose to switch from traditional bond funds into a mix of income, credit and unconstrained bond offerings.
Behavioral finance and institutional considerations help shed light on this rather puzzling behavior.
One explanation is sheer investor inertia. Bond prices' refusal to fall in a sustained fashion has diminished the urgency that some investors feel in reducing their holdings. This year’s higher prices have even attracted purchases from those who tend to respond to past performance.
Second, many investors are hesitant to give up on an asset class that has long played a reliable role in anchoring well-diversified portfolios, enhancing returns and mitigating risk.
Third, other asset classes, particularly equities, aren't deemed as attractively cheap -- and have an unpleasant tendency to sell off faster and further than bonds in bad times.
Finally, the strong recovery of equity markets over the last few years has created investment gains for institutions, such as insurance companies and pension funds, that have long-term liabilities to policy holders and future retirees. To better match their future assets to those liabilities, the institutions are taking their gains and investing them in longer-maturity bonds.
Judging from data provided by the Commodity Futures Trading Commission, the movements in both rates and flows are catching many professional traders by surprise. Despite some recent repositioning, the net short position of non-commercial investors in 10-year Treasuries is the biggest in two years -- meaning speculators have made bets designed to profit from an increase in yields and related outflows. Dealers are similarly positioned: Their net short in the largest in almost a year.
I'm not saying that the great rotation is dead. It may yet surprise professional traders again in future, though in different ways. Rather, it's important to recognize that the application of simple economic principles to markets has to be combined with a good understanding of behavioral finance and institutional realities. Otherwise, what “should happen” ends up testing the patience and agility of many.
This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.
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Mohamed Aly El-Erian at firstname.lastname@example.org
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Mark Whitehouse at email@example.com