Flight to Safety

Since December 2007, mutual fund investors have voted their pocketbook in an incredibly consistent manner. According to the Investment Company Institute, a national association that represents investment companies on regulatory and policy issues, bond funds have gained share from stock funds in every month since then. This winning streak would dominate headline news for any sporting franchise.

Investors have been conditioned for decades to believe that investments in bonds are the safe bet. Prognosticators frequently call a rush to bonds, specifically U.S. Treasuries, a “flight to safety.” And why not? Since 1982, bond yields have steadily declined, thus lifting their principal asset values in the secondary market. This happens because older bonds that pay higher interest become more attractive when newer bonds are issued that pay lower rates—bond prices and interest rates tend to move in opposite directions. So given an economy that continues to look weak, bonds still look like the rational, safe bet.

Until you look harder.

Bonds have a limited life span and limited potential upside for capital gains, while stocks are perpetual and have unlimited upside potential. It’s also worth noting that lately we’ve seen a significant uptick in bond defaults (see chart at right)—and this is within the so-called “investment grade” category, the highest quality bonds available.

Given the level of economic uncertainty, it’s not unreasonable to conclude that the risk for bond defaults will remain elevated, while the reward (yield-to-maturity) remains low. High risk, low return—that doesn’t sound like a “flight to safety.”

On the other hand, a lack of enthusiasm toward stocks improves their price/value relationship, and the financial collapse of 2008 is a major reason for optimism here. Since the financial meltdown, investors—not to mention a significantly weaker economy—have stopped funding bad businesses. Try now, for example, to put together a Pets.com and ask your banker or a Wall Street firm to back the idea. Companies with bad business models simply don’t get capital. Weak economies weed out weak businesses.