Flight from bond funds on the runway?

The deluge of cash into bond mutual funds is slowing, and more money is flowing into those that focus on stocks, showing that a shift may be under way that would hurt borrowers benefiting from record-low interest rates.

North American debt funds reported the lowest volume of deposits in almost two months during the one-week period through Oct. 31, while equity funds recorded the biggest inflows since Sept. 19, according to data from EPFR Global.

A retreat from corporate bonds by mutual fund investors may take hold by the end of next year, according to Bank of America Corp.

Notes are about the most expensive ever, relative to equities, and are underperforming stocks for the first time since 2007.

That may temper issuance, approaching an annual record with almost two months left of this year, if borrowing costs rise from record lows.

“It is only a matter of when the great rotation trade out of bonds and into equities starts,” BofA credit strategist Hans Mikkelsen said. “I’m thinking a lot about the risk that this is not going to be an orderly process, because we haven’t seen it before.”

A Federal Reserve plan to purchase mortgage bonds and suppress borrowing costs has prodded investors to buy company debt rather than Treasuries, which yielded a record-low 1.38% for 10-year notes July 25.

ALL-TIME LOW

Investment-grade yields plummeted to an all-time low of 2.75% on Oct. 29, versus an average 5.08% since 2002, Bank of America Merrill Lynch index data show.

After an average annual return of 10% during the past 30 years, it isn’t mathematically possible for the notes to post comparable returns next year, Mr. Mikkelsen said.

“There’s just more upside for risk-adjusted returns in the equity markets,” said Joseph Tanious, a global market strategist at J.P. Morgan Asset Management, which oversees $1.3 trillion. “The relative valuation between those two asset classes is just completely out of whack.”

Corporate borrowers from General Electric Co. to CIT Group Inc. have sold $1.23 trillion in dollar-denominated bonds this year, exceeding the $1.08 trillion sold in the comparable period of 2009, when a record $1.24 trillion was issued, according to data compiled by Bloomberg.

U.S. corporate-bond funds have attracted $79.9 billion this year, including $22.8 billion for those that buy speculative-grade notes, according to data compiled by The Royal Bank of Scotland Group PLC.

That compares with $14.4 billion in deposits into equity funds, RBS data show.

“We’re bumping up against the natural bounds of performance that credit asset classes can offer,” said Edward Marrinan, a macro credit strategist at RBS.

“As a comparison, equities have a much greater potential upside” as long as company earnings continue at a respectable pace, he said.

Demand for alternatives to government debt has sent yields on U.S. investment-grade bonds to 4.31 percentage points below the earnings yield on stocks, according to Barclays U.S. Aggregated Corporate and S&P 500 index data.

That is 0.25 percentage points above the Aug. 10, 2011, record of 4.56 percentage points less than stocks. It reverses the 20-year average of the debt paying 0.92 percentage points more than equities.

Investors are seeking the debt of riskier borrowers for returns after the Fed said that it plans to hold interest rates at about zero through at least mid-2015 to ignite economic growth and said that it will buy $40 billion in mortgage bonds a month until it sees improvement in the labor market.

UNEMPLOYMENT RATE

Although American employers added more workers than forecast to payrolls last month, the unemployment rate rose to 7.9%, from 7.8%. Growth in gross domestic product will slow to 2% in 2013, from 2.1% this year, according to the median estimate of economists surveyed by Bloomberg.

“BIG DIFFERENCE’

“The equity markets can perform well even when the economy is growing slowly,” Mr. Tanious said.

“There’s a very big difference between a weak economy that’s beginning to deteriorate and a weak economy that’s improving.”

The most likely scenario will be that investors start rotating out of bonds by the end of next year, with outflows accelerating in 2014, at which point investment-grade bonds may start to lose value, Mr. Mikkelsen wrote in an Oct. 22 report.

If interest rates rise more quickly, there could be a “disorderly rotation” out of credit, leading corporates to underperform Treasuries, he wrote.

North American bond funds reported $1.59 billion in deposits in the one-week period through Oct. 31, the least since the one-week period through Sept. 5, EPFR data show.

That compares with an average weekly inflow of $3.7 billion since the beginning of the year.

Investors funneled $1.06 billion into North American stocks funds last week, versus an average weekly outflow of $444.2 million this year, according to EPFR.

The S&P 500 is returning 3.72 percentage points more than dollar-denominated corporate bonds this year, the first time stocks are outperforming bonds for the period since 2007.

As stocks return more than bonds, investors will say, “”Maybe I should start chasing those returns,’” Mr. Tanious said.

“You’re seeing these investors take on more risk appetite,” he said.

“The next move for many of these investors is going to be to go into stocks.”