The death knell for the bond market has been sounded repeatedly as the stock market rallies, but investments in fixed income could be much more "sticky" and less likely to cross into equities than people think.
Investors hoping for more gains in stocks are calling for a secular shift of trillions of dollars out of debt and cash holdings and into stocks, arguing that debt offers too little return for mounting interest rate risks.
However, risk-averse investors may remain as such, analysts say. A recent Morgan Stanley study found so far that very little money has jumped from safer bond markets to riskier stocks. U.S. population demographics and relatively conservative balance sheets mean investors could continue to allocate less to equities than in recent times.
U.S. government bonds have had a 30-year bull run, broken only twice in 1994 and 2004-2005, with benchmark 10-year Treasuries yields falling to around 2 percent today from more than 15 percent in 1980.
With yields now running below inflation, many question whether the inevitable rise in yields will be orderly or panic-driven. That will determine where money in bond funds goes - to higher-yielding assets such as corporate debt, or in quick retreat to short-dated instruments.
In the more bullish scenario, a stronger economy supports most assets. Debt yields rise steadily, but don't disrupt the still-fragile recovery by dampening consumer and corporate borrowing vital to the country's growth. Money may shift from less-risky to more-risky debt, and some into equities.
If growth remains sluggish, however, the risk of disruptions from a bond selloff or an unexpected interest rate hike would rise. In this case, investors spooked by potential losses in bonds won't head to stocks - which would also be at risk. Instead, they would scurry back to shorter-dated debt and cash.
"All else being equal, if the economy keeps sputtering along and rates rise significantly then that's going to be a drag on equities, it means funding costs are higher, mortgage rates are higher and the nascent growth that you had is going to slow down," said Ira Jersey, interest rate strategist at credit Suisse in New York.
Bullish inflows into stocks funds in January raised speculation that investors are increasingly turning toward equities, though new allocations to bonds were also strong.
Investors added $38.07 billion to equity funds in the first four full weeks in January, while bond funds saw $31.58 billion in inflows, according to Investment Company Institute.
Money market funds had outflows of $9.62 billion in the first four full weeks of the year as retail investors pulled out of the funds at a faster rate than institutional investors increased allocations to the funds, the ICI data show.
To some, equity bulls may be overestimating how willing companies may be to tie up funds in riskier investments, instead of keeping funds highly liquid and on hand for businesses needs. More stringent credit conditions are also making companies and consumers hold onto higher cash positions than before the financial crisis.
"People have been touting this wall of cash theory for well over a decade now and the balances of cash overall just keep going up. It's not because people are more paranoid, though there is some of that going around, its because a bigger economy needs a bigger pool of cash to lubricate it," said Peter Crane, President at Crane Data, which analyzes money fund investments.
Asset allocations may be more entrenched than many think. Many funds have stringent rules on the type and quality of assets they can purchase and changes to such policies is slow.
"There is money that is structurally allocated to bonds or equities or cash. Changes to these allocations are a marginal process, they change valuations around the edges," said Alex Roever, a money market analyst at JPMorgan in New York.
New regulations that will require more assets be pledged to back derivatives and other trades may also support bond demand, as higher haircuts for pledging equities may make the securities relatively less attractive.
Demographic trends are also likely to keep many consumers more risk averse for years to come. The baby-boomer generation is rapidly heading toward retirement, and they may be unwilling to risk losses on stocks, even if bond yields remain measly.
"I don't know how many 60-yearolds are going to be moving out of bond funds that they just bought in the past two years and moving them into stocks," said Jersey.
SLOW RISK EXTENSION
Investors have been slowly leaving money market funds in search of higher yields since 2009, as Federal Reserve chairman Ben Bernanke held rates at record low levels and bought billions in long-dated debt in a bid to push investors to riskier assets.
But while some of these investors have shown a stronger risk appetite that could make them likely to make a further leap into stocks, most have remained relatively risk averse and may be unlikely to make such the shift anytime soon.
A Jan. 25 study of fund flows by Morgan Stanley found that of the approximately $850 billion expansion of the U.S. monetary base in 2008, most remains in relatively low risk assets. Asset shifts since 2009 remain largely from cash to the bond markets.
From 2009 to January of 2013, $1.175 trillion flowed into bond funds, while $1.15 trillion was pulled from money markets funds. Stocks funds saw only $149 billion in inflows in this time period, Morgan Stanley said.
Of all bond investors, those that shifted into high-yield debt may be the most likely to make the move into equities, though they represent only 8 percent of flows into bond funds since January 2009, Morgan Stanley said.
"We find it much less likely that more risk-averse money invested currently in high grade bonds, short-to-intermediate duration high grade bonds, and government-backed bonds, would leapfrog the risk spectrum into equity funds directly," Morgan Stanley's head of U.S. interest rate strategy Matthew Hornbach said, in the report.
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