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Bond fund rush: Send in the clowns?

On pace for $300B in inflows this year as risks continue to rise; could get caught in mid-air

By Jason Kephart

Nov 21, 2012 @ 10:12 am (Updated 1:41 pm) EST

bonds, high-yield, mutual funds, etfs

There's no slowdown in sight for the great bond-buying spree as its fourth year draws to a close and the risks continue to pile up.

Bond funds are expected to take in $300 billion in inflows this year, outpacing both 2011 and 2010, according to research firm Strategic Insight. Investors have poured more than $1 trillion into the asset class since 2009, doubling the total assets in bond funds to $2.4 trillion.

Investors' allocation to bonds, which includes both mutual funds and exchange-traded funds, has climbed to 26%, double what it was in October 2007, when the stock market reached its peak, according to Morningstar Inc.

The continuing love affair with fixed income is careening into dangerous territory, warned Michael Gitlin, director of fixed income at T. Rowe Price Group Inc.

“Fixed income is more risky than at any time in the last few years,” he said Tuesday at a press briefing on the firm's investment outlook for 2013.

Not only has the historic amount of deposits driven yields down to record, or near record, low yields, but the constant demand is also leading to a decrease in the quality of credits being issued.

This year, investment-grade credits have seen more downgrades than upgrades for the first time in three years. In the high-yield space, the upgrades and downgrades have canceled each other out after two straight years of net upgrades.

“You're getting all-time low yields for more credit risk,” Mr. Gitlin said. “There are really stretched valuations in fixed income right now.”

And if the valuations weren't bad enough, there's also a looming liquidity problem should there be a big sell-off in bonds. The net inventory at primary dealers stood at around $50 billion as of the end of October, down from $300 billion in 2007.

“There's no backstop to buy when everyone is trying to sell,” Mr. Gitlin said.

Still, he does see some bright spots in local-currency emerging-markets debt.

It hasn't seen as much of a run-up as dollar-denominated debt, and with the dollar in a secular bear market, according to Mr. Gitlin, the local currencies should appreciate against it in the future, giving bonds an extra boost.