Avi Nachmany, Director of Research, Strategic Insight, an Asset International Company

 

I am fascinated by tectonic plate shifts. Deep under ground, imperceptible most days, these parts of the earth's crust drift perhaps a few inches per year - and then suddenly, one plate crashes into another, triggering a seismic shock, an earthquake, a volcanic eruption, a tsunami like the one devastating many communities in Southeast Asia five years ago. I was introduced to the enormous impact of geology by the fantastic historian-geologist Simon Winchester (www.simonwinchester.com); I recommend his book, Krakatoa: The Day the World Exploded: August 27, 1883, to learn about trade routes, ancient map making, the Indo-Australian Plate, and so much more, or, understand important aspects of the history of the American West in his A Crack in the Edge of the World: America and the Great California Earthquake of 1906.

We do not know when the next earthquake will shake San Francisco, or the next plate movement will trigger another tsunami. We only know it will happen.

 

I got to worrying about tectonic plates as we were publishing our mutual fund industry Forecast for 2010 (find out more about the report here: http://www.sionline.com/published/2009-whitepapers/main.asp ). 

Beginning in the late 1970s and continuing through the entire modern era of the mutual fund industry,  interest rates have been falling as illustrated below. The sharp decline of interest rates in 1984-87 triggered the first boom in purchases of bond mutual funds by individual investors (and coincided with the 1986 founding of Strategic Insight with our first report, "Mutual Funds: Investing in the Future.")  Subsequent interest rates down-trends triggered new waves of bond fund purchasing activity, shown below.

 

 

Then, in 2009, the pace of bond-fund purchasing exploded. For all of 2009, new sales of bond funds rose 50% from their 2008 pace. This meant that investors poured roughly $400 billion - by far an all-time record - into bond funds on a net basis (purchasing less withdrawals).

 

The insatiable interest in bond funds during 2009 was not surprising. Shell-shocked savers and investors were holding more than $10 trillion in cash throughout the banking system and money market mutual funds, on which they often were earning only fractions of a percentage point (you can't even buy a Starbucks latte with the monthly interest on a $100,000 deposit). We see as inevitable the further migration of investor cash into higher-yielding income vehicles - in other words, bonds and bond mutual funds - based in part on their backwards-looking appeal (25+ years of falling interest rates and correspondingly high total returns) of bonds and bond funds, and in part on the lingering skepticism about the stock market recovery. Strategic Insight projects bond fund sales to rise a further 17% in 2010.

 

 

In our view the fastest sales acceleration last year - and projected to continue in 2010 - is in the Corporate Bond fund sector, as investment opportunities continue to shift to analysis of companies' credit risks and away from US Treasury bonds. Thus, the US Government Bond fund sector is the only bond fund category showing sales moderations in our projection. The "Strategic Income" sector - including multi-sector funds investing in the US and internationally - remains the largest bond fund sales sector. Among Municipal Bond funds, national programs outgrew single-state funds in 2009 and are projected to repeat such performance next year.

 

Bond fund demand will continue to be fueled by investors shifting money out of bank deposit accounts earning near-zero rates. Even when the Federal Reserve starts moving short-term interest rates higher, such change would be slow, measured, and driven by feedback from the real economy. For savers tired of earning zero, the appeal of bond funds - with their 4%+ annual dividend promise, 2009's 15%+ total returns, and 25-years of tailwinds, remains irresistible.

 

 

These trends have been visible in 2009 and are likely to continue this year. But like the Indo-Australian plate, slowly pushing Everest even higher, the tectonic plates of rising global interest rates are also moving, yet in less visible ways to most investors. US Government debt, the growing supply of dollars, competition for global funding away from the US dollar, and other oft- mentioned triggers of inflation, are all lining up to reverse the 30-year trend of falling interest rates.

 

Is the ravenous demand for bond funds today signaling the next bubble, likely to burst with a huge seismic bang in the coming years? Slow economic recovery and very slowly rising short-term interest rates suggest that we might hit a point - possibly in 2011? - when longer-term interest rates start to rise significantly and the value of bond funds that invest in longer-term debt start to decline. By the time that happens, safety- and income-seeking investors will have added $1 trillion-plus to their bond fund portfolios from 2009 through 2001, and will then be holding $3 trillion of assets (with trillions more of bonds held by individuals and institutions outside mutual funds).

 

How should financial advisors, pension plans, broker-dealers, and investment management companies collaborate to guide such investors in the coming years? Should investors be nudged, for example, into investments better-suited for rising long-term interest rates and an inflationary environment? What can be done beyond education and disclosure?

 

We do not know when next the earth shakes, a volcano erupts, or a tsunami sweeps. All that we know is the predictability of it happening, given that tectonic plates are moving. All of us - advisors, fiduciaries, and investors alike - should pay close attention to the interest rate seismographs.

Read Part II
Planning for 2010, II:
"There's No Way You Can Bet Against America & Win" (Warren Buffet)

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