Investors are exiting stocks en masse for bond funds but appear to have no idea what they are getting into
With investors exiting stocks en masse for the safety of bond funds, it's disconcerting to learn that they have no idea what they're getting into.
In an Investor Literacy Test conducted by the Vanguard Group, the second-largest US mutual fund firm, nearly 70% of the 1,000 randomly selected investors surveyed did not understand the inverse relationship between bond prices and interest rates, according to a press release posted on the company's web site.
Startling, huh? Those of you reading this probably roll your eyes every time you read the de rigueur explanation in the daily credit market report that a bond's price moves inversely to its yield. To think that 70% of folks throwing money at bond funds have no idea of the interest-rate risk is about as scary as, well, investors chasing internet and technology stocks in 1999 and 2000 without any understanding of the inherent risk.
US mutual funds saw a $104bn net inflow into taxable and tax-exempt bond funds through August of this year, according to the Investment Company Institute. (I'm lumping them together because 58% of the respondents to Vanguard's Literacy Test didn't know that income from municipal bonds was federally tax-exempt.)
Vanguard has tested investor literacy every two years for the past eight years. The average score (100 is perfect) was 51% in 1996, 49% in 1998, 37% in 2000 and 40% in 2002.
Investors might not understand the inverse relationship between price and yield on a bond, but the test's graders could not have overlooked the inverse relationship between literacy and the market mania.
'The bull market drew in a lot of new investors,'' says John Woerth, a spokesman for the Vanguard Group.
New investors scored worse (34%) than experienced investors (42%) this year, although investors with an average level of self-rated investment expertise beat the experts (45%), according to Vanguard.
College graduates scored better than those without formal higher education; men outperformed women; older investors did better than younger ones. Perhaps the quirkiest result was that the lowest score, 16%, was on the question about the goal of indexed mutual funds. Given that Vanguard is best known for pioneering indexed funds, fund managers mimic the portfolio of an existing index, such as the Standard & Poor's 500, rather than select stocks to buy, the irony resonated with the test's designers.
What investors know is that bonds, especially risk-free Treasuries, continue to soar (the yield, which moves in the opposite direction to the price, keeps tumbling) while stocks move relentlessly lower. The S&P 500, down 31% year to date, sits at a five and a half year low.
'Behavioural economists would say that the madness of crowds is more important than the mean expected value of outcomes,'' says Bob Barbera, chief economist at Hoenig & Co in Rye Brook, New York. Barbera says the enthusiasm for Treasuries at minuscule yield levels is not unlike the conviction about stocks in early 2000.
'In 2000, you could have made rational calculations that the future implied by the financial markets was extraordinarily unlikely,'' he says. 'A similar calculation can be made today.''
Whereas at the start of 2000, the markets were projecting 'real growth above 4% in perpetuity, now the projection is for nominal growth well below 4%,'' he says.
The former forecast proved misleading. Barbera suspects today's glum outlook, reflected in depressed Treasury yields and stock prices, will turn out to be equally off base.
Vanguard's investors aren't the only ones chasing positive returns without understanding the odds.
'It might be a novel proposition in a market that has institutionalised the concept of buying high and selling low, but the level of nominal bond yields has a bearing on their subsequent real returns,'' says Tim Bond, global strategist at Barclays Capital Group in London.
High nominal yields historically deliver high real returns; low nominal yields do just the opposite, Bond says.
Bond compared the historical yield on long-term bonds with the subsequent 10-year real total return.
What he found was the odds of the 30-year bond, currently yielding 4.65%, producing a positive return over the next 10 years are less than 10%, based on a study going back to 1935.
When he expanded the study's range back to 1926 to include 'the Great Depression and the Great Deflation,'' the odds improved to about 20%.
Those aren't the kind of odds most investors are willing to take. Then again, if the relationship between bond prices and yields is a mystery, the returns on their bond mutual funds in the next few years may come as a big surprise.
Bloomberg newsroom, New York
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