1/5/2011 3:42 PM ET|
The next big 401k washout
The bear market led throngs of investors to flee stocks for the relative 'safety' of bonds. But with the economy changing, those investments now threaten our retirement savings.
It's hard to blame investors for retreating to bonds over the past two years.
During the 2007-2009 bear market, U.S. households saw their 401k's and other retirement plans shrink by more than $3 trillion -- around 35% of the pre-recession total.
Of this, $2.4 trillion came from stock losses. The more you had in stocks, the more you likely lost.
Combine that with the 2000-2002 tech crash -- and a variety of economic calamities, panics and cases of fraud -- and you get the worst-performing 10-year period in the stock market since the 1930s.
So despite the economy's return to growth in the summer of 2009 and the stock market's 91% rally from its low, shell-shocked investors have stuck with the perceived safety of bonds and shunned stocks.
According to Credit Suisse, a whopping 95% of newly invested money has flowed into bond mutual funds since the beginning of 2009. Now, bonds account for 38% of all mutual-fund assets -- which is where most nest egg dollars sit -- up from 24.4% in 2007 and 19.8% in 2000.
This safe-and-sane approach leaves us at least secure, right? Unfortunately not.
A very long rally in bonds is coming to an end; a huge correction could be in the offing. So this flight to safety has set up a lot of everyday investors for the next great 401k washout.
Still living in fear
This flight to bonds has been driven by uncertainty and fear: A September survey (.pdf file) of investors by the Investment Company Institute found that investors' willingness to take risk remains well below pre-recession levels and continues to slide among the under-35 cadre entering their prime savings years. The "safety" of fixed-income investments has almost become an obsession; a Morgan Stanley analysis of ICI mutual-fund flow data shows bonds are now more popular than stocks were even at the peak of the equity bubble in 2000.
But like all bubbles, this will end badly for those who don't recognize it for what is.
The great bond bull market -- which accompanied the long decline of interest rates from a high of 22.4% in 1981 to nearly zero now -- is coming to an end as rates start moving higher. This was the subject of my most recent column, as well as columns from November (on the Fed's $600 billion "QE2" money-printing initiative) and September (on inflation). The drivers will be a shift in the supply/demand balance for money, rising inflationary pressures and faster economic growth. With 10-year Treasury yields at 3.4% now, analysts at Jefferies are looking for rates of 5% later this year, while Morgan Stanley is looking for 4%.
While those gains don't sound drastic, investors in long-term bonds will be handed large losses as duration -- the leverage that's implicit in long-lived fixed-income assets -- comes back to bite them. It's like buying stocks on margin; the potential gains go up, but so do potential losses.
Duration bolsters returns when rates are falling and bond prices are rising, as they were during the 2007-2009 bear market for stocks. It magnifies losses when things reverse.
I'll use an example to illustrate.
Say you've invested in a 10-year bond that pays one payment at maturity (a "zero-coupon" bond with a 10-year duration), and interest rates are at 2%. Then, rates increase to 4%. Not a big deal, you might think. But it would cost your bond around 20% of its value. If the bond matured in just two years -- a shorter duration -- your loss would be cut to 4% for the same change in rates.
The flight has begun
The market is starting to do this math. Bond yields are up from 2.4% in October and a low of 2.1% in December 2008, pushing bond prices down. This has the so-called "smart money" moving out of bonds and into stocks.
For the week that ended Dec. 15, 2010, bond funds tracked by EPFR posted their biggest outflow since 2008 and posted outflows in six of the final seven weeks of 2010. For November and December, equity funds took in more than $51 billion -- barely enough to push their annual total into positive territory.
VIDEO ON MSN MONEY
With what money Paolo-Pablo. The government took all of mine and is still after the rest of it. I'm not rich enough to get the big tax breaks.
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