Money flows to bond funds, but risks climb

There is 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 post $300 billion in inflows this year, outpacing 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, according to Morningstar Inc.

The continuing love affair with fixed income is careering into dangerous territory, said 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 last Tuesday at a press briefing on the firm’s investment outlook for next year.

Not only has the historic amount of deposits driven yields down to record or near-record low yields, but the constant demand has led 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 sector, 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.

And if the valuations weren’t bad enough, a liquidity problem looms should a big sell-off in bonds occur. The net inventory at primary dealers stood at about $50 billion as of the end of last month, down from $300 billion in 2007.

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

Still, he sees 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, giving bonds a boost.

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