Are Bond Fund Outflows a Warning Sign? Not yet.

Tuesday, December 7, 2010

The Wall Street Journal proclaims, “As Bonds Flag, Stocks Beckon” (Abreast of the Market, by Mark Gongloff, December 6).

Here’s their take:

“After a stellar two-year run, the bond market is stumbling and a number of investors are betting that stocks will post better returns in the coming months.

“Among the signs being held up as evidence: Investors in the past two weeks pulled money from bond funds for the first time in almost two years, and there are indications of a growing move toward stocks.”

Yes, bond prices slipped in November and, yes, stock prices have been rising. However, fund investors have yet to change their ways. Here’s the real picture:

Totals give wrong picture

The WSJ looked only at the total mutual fund flows, but the cause wasn’t a growing dislike for all bonds. Rather, it was just municipal bonds. For the latest two weeks reported (through November 24) by the Investment Company Institute, total bond funds had a $(6.1) billion outflow. However, that total was composed of a  $1.8 taxable bond fund inflow and a $(7.9) municipal bond fund outflow.

Note: The other side of the article’s title, “stocks beckon,” also lacks support. During the same two-week period, there was a worsening picture, with $(5.4) flowing out of US stock funds.

The article is a good example of misleading investment commentary. Starting with a misreading of data, unsupported explanations and conclusions are then drawn.

What the data really mean

Knowing that the bond outflows were entirely caused by municipal fund sales, the question is, “Why?” The likely explanation is tax-selling activity. Municipal bond fund holders, a tax sensitive group, are willing to take year-end actions to improve their tax situation. The graph below shows the monthly flows for taxable and municipal bond flows, highlighting the year-end movements.

Note that 2009 did not exhibit the normal year-end tax-selling pattern. The reasons are explained in this article: “Closed-End Funds Avoid Customary Year-End Sell-Off” (The Bond Buyer, by Dan Seymour, January 7, 2010).  [The same effects for closed-end funds apply to mutual funds.]

“December is traditionally a cruel month for closed-end funds [CEFs]. Investors looking to shield income from taxes usually sell CEFs for tax purposes. Municipal closed-end funds suffered losses of 1.09%, 0.17%, and 0.08% in the final month of 2008, 2007, and 2006, respectively. It did not happen in 2009.

“Normally, tax-conscious investors toward the end of the year sell CEFs at a lower price than they bought them for. That sale locks in a capital loss. The loss offsets other taxable income.

“Investors can only save on taxes by selling a closed-end fund if they sell the fund at a loss. The asset did so well in 2009 that it was hard to find funds trading at lower prices.”

So… No sign yet that investors have changed their mutual fund buying/selling habits based on a shift from bonds to US equities. I believe that will come, but the latest mutual fund flow data does not show it yet.

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John Tobey on Seeking Alpha

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December 2010