Fund Flows Favor Bonds Over Stocks, but Returns May Not Follow

Posted by lplresearch

Economic Blog

After pulling back in the first quarter of 2020, flows into bond mutual funds and exchange-traded funds (ETFs) dominated stocks in the second quarter. As shown in the LPL Chart of the Day, the second quarter is consistent with recent history, as bond flows have topped stock flows in 15 of 18 quarters going back to the start of 2016.

“While there may be some natural explanations for bond flows, there is also concern that bond enthusiasm has moved toward an extreme after a multi-decade bull run,” said LPL Chief Market Strategist Ryan Detrick.

While bonds remain an important part of a diversified portfolio, returns going forward will likely become more muted due to low yields, less scope for rates to move lower (which supports prices), and the possibility that rates increase as the recovery progresses.

View enlarged chart.

A number of factors may be contributing to the differences in flows:

  • The bond market is just bigger than the stock market.
  • Demographics may be having an impact as baby boomers move to secure their nest egg in the face of potentially volatile markets.
  • Demographics may also be driving an accelerating hunt for yield in a low yield world.
  • Some investors may be buying what the Federal Reserve is buying.

The biggest concern would be if bond flows reflect a growing level of exuberance as a rising rate environment becomes a more distant memory and expensive valuations seem increasingly sustainable. We still believe there are forces that will help limit rate increases in the near term, including a supportive Federal Reserve, foreign demand for US Treasuries, a lower baseline for global growth, and an economic recovery that will likely continue to advance, but not in a straight line. But economic improvement is likely to lead to higher rates over time.

Bonds remain an important asset class, especially for income-oriented investors, but interest rate risk needs to be managed. As discussed in our Midyear Outlook 2020, allocations to bond sectors like mortgage-backed securities and investment-grade corporates may contribute to portfolio resilience looking out over the rest of the year and into 2021.


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