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As investors rush to safety, bond lifeboat becoming bogged down

As Monday's global stock market plunge reminds us, it's phenomenally difficult to be an investor these days. You can keep money in cash and earn next to nothing, or expose yourself to a stock market where repeated ups and downs leave people mentally exhausted and none the richer.

But many investors are making a tough situation even tougher for themselves. They're fearful of stocks, and not without reason - yesterday's drop means the S&P/TSX composite index has now lost 14.2 per cent in the past year. But they're flocking to the false security of bonds.

Recent mutual fund industry sales figures show that bonds are decisively winning the battle for hearts and minds. Bond funds are taking in vast amounts of money and equity funds seem almost to be a dying category. This imbalance will not end well.

The Investment Funds Institute of Canada says its members had net sales of $7.1-billion in bond funds for the first quarter of the year, up from $871-million in the same period of last year. Balanced funds, which mix bonds with stocks, took in $10.5-billion for the first quarter, down from $14.1-billion last year.

As for equity funds, investors cashed out almost $3-billion more than they put in over the first three months of the year. "As of March, net demand for equity funds remains near record lows," Frank Hracs, chief economist at Credo Consulting, wrote in a recent commentary on fund sales.

Behind this trend is what appears to be a crisis of confidence in stocks as an investment for regular people. Trading volumes on North American exchanges hit four-year lows in 2011 and the retreat of retail investors is one explanation. The research firm Investor Economics reports that $5.70 of every $10 in financial wealth was held outside the stock market at the end of last year. That's down from just over $6 at the end of 2008, but way off the low of $4.70 reached in 2006.

Bonds have picked up some of the money leaving stocks because they did well for investors following the 2008-09 stock market crash, and also because they're seen as being safe. In a sense, they are. The kinds of bonds most investors own either directly or through mutual funds are issued by governments and big companies that are very unlikely to default on their debts.

And yet, the rush to buy bonds today suggests unsound thinking, if investors' reasoning is to have a bulletproof place to invest. When the global economy stabilizes and interest rates start creeping higher, the bond funds being bought today are likely to fall in value.

Last week, the Bank of Canada sent a signal that the short-term rates it controls could rise sooner than expected. This puts the bond market on alert. One of the immutable rules of investing is that when rates rise, bonds and bond funds fall in value.

We've been looking ahead to interest rate increases for a while, yet bond funds continue to pull in big money. "It's some kind of delusion of safety," Mr. Hracs said.

Sure, almost all investors need some bonds, but many people now have too much of their money riding on the fixed-income portion of their portfolio. One possible result of a bonds-first investing approach is that retirement savings will generate disappointing returns.

Don't look back at bond funds results - the three-year compound average annual gain of 6 per cent will not be repeated unless we lapse into a full-blown depression. More likely, returns will be in the low single digits.

If your registered retirement savings plan is mainly powered by bond funds, you may have to contribute more money every year to reach your financial goals. The alternative remedy would be to resign yourself to working longer so as to build up a bigger RRSP. Over time, a balanced portfolio of stocks and bonds is the better approach. You'll have more risk, but the potential for higher returns offsets this.

The saddest aspect of the rush into bonds is that it came at a time when the smart move was to buy stocks. True, the Canadian market has been disappointing lately. But it has enjoyed a strong rebound since the crisis: Over the three years to March 31, it gained 15.6 per cent a year.

How long until investors come back to stocks? "That's a tough one," said Eric Kirzner, a finance professor at University of Toronto's Rotman School of Management. "Confidence should have come back a year ago."



Here are some thoughts on today's stock market conditions from Eric Kirzner, a finance professor and holder of the John H. Watson Chair in Value Investing at University of Toronto's Rotman School of Management.

On how much more upside there might be in the market:

"I'm not saying this bull market's over, but it's getting pretty long in the tooth."

On recent fears of a renewed market plunge:

"Every time the market looks like it's coming apart, it doesn't."

On what to buy now:

"I'd be looking at some areas that haven't participated in the market upswing. I like the consumer discretionary stocks. Gold miners have been beaten down badly, but I don't know if I'd jump in yet. Some of the [real estate investment trusts] look attractive."

Rob Carrick

© 2007 The Globe and Mail. All rights reserved.

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