Why the Rush to Fixed Income May Be Dangerous
November set a record for money flowing into exchange traded funds -- $25 billion for the month and $218 billion for the year, according to data from BlackRock Investment Institute. Yet what is perplexing from the point of view of financial experts is that among the varieties of ETFs, fixed income has already set a record this year, with nearly $70 billion in flows year to date (surpassing the $50 billion of 2011).
Why would investors flock to fixed income assets, where yields are not just bad, they're awful? The answer is: It's complicated.
"We've definitely seen a general trend over the course of the last year from equities to fixed income," said Brad Thompson, CIO of Stadion Money Management in Watkinsville, Ga. "There's the general conservative nature of many investors in the face of all that's going on globally.The 'fiscal cliff' adds to it. And also you've got a lot of people trying to grab yield."
Given the timing of the rush to fixed income ETFs, it appears that worries about presumed higher taxes next year as a result of fiscal cliff negotiations may be the trigger. Yet the market is doing well now, and Thompson said his firm is "bullish" off the rally started in November and fully invested in equities. It seems, then, that investors are leaving money on the table.
"Retail investors have a tendency to make a move at the wrong time," Thompson said.
(Read more: Fixed Income Outlook)
Robert Whaley, professor of finance at Vanderbilt University who invented the VIX index (also known as the "fear index"), said he, too, is perplexed by recent investor behavior. "I recognize the fiscal cliff is around the corner, but people seem to be pretty comfortable that something will be done," he said. "I don't see the anxiety that would cause a flight to quality into fixed income."
For proof, he pointed to the VIX. During the financial crisis, it reached an intraday high of 89.53 on Oct. 24, 2008. In August 2011, after the U.S. lost its AAA rating and the market reacted with intense volatility, the VIX hit the high 40s. Today, the VIX stands at around 16, a fact that makes Whaley think investors diving into fixed income assets are wrong-headed or misinformed.
Still, there is apparently magic associated with fixed income assets, particularly fixed income ETFs.
ETFs exploded in popularity just before and during the financial crisis. They became even more popular as a result of the Flash Crash in 2010. By that point, investors were terrified of market volatility and clamoring for the ability to trade intraday. Even today they like the ETF's stock-like nature; if they think the proverbial sky is falling, they can bail out of the market at any moment during the day and feel secure. The problem is, sometimes they bail at the low of the day.
Meanwhile, if held long enough, ETFs are cheaper than mutual funds because their overhead expenses are lower, but only if held for perhaps five to 10 years – which, incidentally, many investors don't do because they get trigger-happy and sell.
Ernie Dawal, chief investment officer for SunTrust Bank, is a fan of ETFs. He likes the ability to trade them at any time, and he likes their lower fees. Another reason: "Investor psyche," he said. "Fund managers have found it's hard to beat the indexes consistently. So a lot of investors are saying, just give me the beta and I'll forgo the alpha."
All of which brings us back to the flavor of the month: fixed income ETFs. Because yields on all fixed income assets are low, investors notice any overhead cost since it eats into their yield. So a bond fund suddenly looks less appealing because of its management cost.
And that's the main reason for the rush to fixed income ETFs, according to financial experts.
Meanwhile, investors in general have lost faith in the markets because of the events of the last four years, plus what is facing them in 2013: Europe's debt crisis, the fiscal cliff showdown, and higher taxes.
"This trend has been pronounced since the beginning of the recession," Dawal said. "And now people are worried about Europe and the fiscal cliff. We simply don't know what will come out in the wash. That uncertainty manifests itself in volatility, so you have a flight to quality. And rightly or wrongly, people are listening to the Fed saying it will keep interest rates low through 2014, which has given them a perceived sense of safety in fixed income."
But there may be problems with this reasoning. First, most people believe the fiscal cliff will be resolved; once that happens, there is good reason to think there will be a stock market rally, since so many people and corporations are sitting on the sidelines holding cash.
And second, even though Fed Chairman Ben Bernanke has continued to signal that interest rates will remain low, rates are so historically low that they have to go up eventually. And when that happens, bonds will suffer, particularly longer-term bonds. When rates rise, long-term bonds suffer the greatest price declines because the longer timeline means greater uncertainty.
Fixed income instruments – such as fixed income ETFs – are therefore vulnerable to losses.
On Wednesday, Goldman Sachs CEO Lloyd Blankfein said as much: "One of the big risks that's looming is complacency. People are once again complacent about the low level of interest rates," he said at The New York Times DealBook conference.
Dawal said he, too, is concerned: "When we talk to our clients we recommend equities over bonds," in part because of the risk of rising rates.
"If something started to happen – if rates go up or if the Fed reversed its policy – you will see that run for the door when everyone tries to unwind their fixed income portfolio," said Dawal.
Until then, though, it's likely fixed income will continue its record-setting ride.