Cognitive Dissonance in the Bond Market

To put it bluntly, investors are overly fond of bonds in the face of mounting risks that most acknowledge, but few seem willing to protect against. The proof is in the flows. According to Morningstar, over the first nine months of the year, investors pulled about $1.6 billion from the eight major alternative fund categories, and withdrew about $6.3 billion from the 18 major equity fund and ETF categories that we track. At the same time, they’ve added approximately $193 billion of new money into fixed income funds and ETFs. In fact, of the 18 major fixed income categories that we follow, 13 have experienced inflows this year. Investors seemingly can’t get enough of all things fixed income.

But as reported by ThinkAdvisor, an analysis by Goldman Sachs this week warned that, “A one percent increase in interest rates could inflict a $1.1 trillion loss to the Bloomberg Barclays U.S. Aggregate Index… representing a larger loss for bondholders than at any other point in history. With the bank predicting the selloff in bonds has further to run, that remains “far from a tail scenario.”

Investors need to be managing duration risk and they need to be looking at asset classes or strategies that can improve upon the pathetically low expected returns for fixed income. A look at the work by GMO (free registration required) and Research Affiliates, two of the heavy weights in the industry when it comes to asset allocation, indicates that investors in U.S. investment grade debt could expect real returns of -2.1% annualized over the next seven years (GMO), and/or 0.5% real annualized returns for the next ten years (Research Affiliates). If those forecasts come even close to being true, investors will undoubtedly look back and wonder why on earth they continued to plow money into bond funds.

Admittedly, there aren’t many places to look to fulfill the competing goals of improving upon the return profile of a diversified portfolio, while properly managing duration, credit, inflation and equity risk, to name a few. But alternative strategies – managed futures, long/short equity, market neutral, global macro, option writing – have to be given serious consideration. Investors need to get over the fact that fees are higher relative to ETFs and they need to stop comparing the performance of alternatives to straight equity as we sit here eight years into a bull market. The kind of Monday morning quarterbacking that is going on in New York right now is exactly the wrong approach.

Losing money comfortably, that is, accepting zero to negative real rates of return on fixed income because fees are low, or because investment grade debt has “always” played a major role in investor portfolios, borders on…well, you can fill in the blank.