When interest rates rose in May 2013, taxable bond funds¹ subsequently experienced considerable outflows. Investors in taxable bond funds redeemed roughly $121 billion in 2013², the industry’s largest single-year cash outflow in our observable history.
The news media sensationalized these outflows as a dramatic sell-off—a virtual ‘bond-mageddon,’ if you will.
While I acknowledge that bond funds experienced significant outflows, they were not unexpected, unprecedented, nor comparable to 1994, the prior worst year, as many articles claimed them to be.
Naturally, the follow-up question is, how can a record year of bond outflows not be considered unprecedented? This reminds me of a George Carlin joke: ‘Some people see the glass half full. Others see it half empty. I see a glass that’s twice as big as it needs to be.’ As with Carlin’s quip, it’s all about putting the figures in perspective. It’s all about context. For example, a rise of 300 points in the Dow (Dow Jones Industrial Average) on January 2, 2014, would have been very different from a 300-point rise in the Dow on January 3, 1994, reflecting increases of 1.8% and 8.0%, respectively.³
Similarly, looking at the cash-flow figures alone can be misleading. What is largely ignored when discussing investor cash flow is the level of base assets, or the starting period of the assets under management. As you can see from the blue bars in the chart below, the $1.8 trillion in assets in taxable bond funds at the beginning of 2013 was 6.5x higher than the $286 billion in these funds at the beginning of 1994. Given such a large asset base, there will likely be proportionally more cash flow into and out of these funds. When we compare cash flows to the base assets, an entirely different picture develops. As a percentage of base assets (green bars), the –6% cash flows from taxable bond funds in 2013 fell far short of the –16% cash flows in 1994. So while the glass may not be twice as big as it needs to be, the size of it does need to be considered.
I don’t want to dismiss the magnitude of the outflows in 2013. After all, $121 billion is a staggering amount. However, I do want to put a little more perspective around it.
First, remember the zero-sum game. The $121 billion in mutual fund and ETF redemptions required ‘other’ investors (not in mutual funds) to be the buyers of the same bonds. These buyers found value in the bonds at the higher yields, and the bond market cleared and matched those selling to those buying, which is a very healthy sign for any market.
Second, despite last year’s outflows, taxable bond funds still had extremely healthy inflows over the three- and five-year periods ended December 31, 2013, of more than $160 billion and $530 billion, respectively (see the figure below). This suggests that investors may have not abandoned bonds but maintain a pretty high degree of confidence in the asset class.
With these large redemptions, questions regarding liquidity in the market are not surprising. In response, I would point to the recent past, i.e., the months following May 2013, when yields rose. Despite the outflows, the bond market and bond funds continued to trade very well, and it was business as normal, just as it was in 1994.
The bottom line: I would caution investors from reacting to short-term movements in the market and to focus on why bond funds are in their portfolios. High-quality bond funds⁴ continue to be great diversifiers against the potentially larger losses of stock holdings. This has largely been the case throughout the markets’ history, and we’ve seen it again in the first few weeks of 2014. Investors who stayed the course were rewarded in January as high quality bonds had positive returns as stocks were falling. And investors appear to be recognizing the role of bonds, as is evident by the commitment of their investment dollars, both in the first 5 weeks of 2014 and over the longer term.
I would like to thank Yan Zilbering and John Woerth for their contributions to this blog.
1 Taxable bond funds refer to traditional U.S. open-end bond funds and ETFs, classified by Morningstar as Corporate Bond, Inflation-Protected Bond, Intermediate Government, Intermediate-Term Bond, Long Government, Long-Term Bond, Short Government, Short-Term Bond, and Ultrashort Bond.
2 Source: Morningstar, Inc. December 2013.
3 Based on index levels at open of 16,572.17 on January 2, 2014, and 3,754.09 on January 3, 1994.
4 A bond whose credit quality is considered to be among the highest by independent bond-rating agencies.
All investing is subject to risk, including possible loss of principal.
Investments in bonds are subject to interest rate, credit, and inflation risk.
In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss.
Past performance is no guarantee of future returns.