For many, bonds vs. stocks is no contest

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The numbers showing inflows and outflows of money in the mutual fund industry over the last few months tell us two things:

First, the typical American investor won’t be at all surprised if the stock market takes a dive.

Second, that same investor could be very surprised if something bad happens to the bond market -- say, if interest rates were to shoot up, devaluing older bonds.

As Wall Street has continued to push higher this month U.S. stock mutual funds have been suffering net cash outflows, according to data from the Investment Company Institute, the funds’ trade group.

Domestic stock funds saw a net $2.04 billion in cash flow out in the seven days through Sept. 16, the latest data available from the ICI. That followed an outflow of $1.75 billion in the week ended Sept. 9 and an outflow of $3.35 billion in the week ended Sept. 2. All told, that’s the heaviest amount of net selling in domestic equity funds since March -- when the stock market was reaching 12-year lows. Now, note that we’re talking about small amounts relative to the $3.5 trillion or so in total domestic stock fund assets. But it’s the trend that’s instructive: The public, on balance, has been exiting even as the market has been rallying.

It’s just the opposite with bond mutual funds, which have about $2 trillion in total assets: Money has poured into those funds this month, exceeding what already were heavy inflows in July and August.

Bond funds (government, corporate and municipal) took in a net $12.7 billion in new cash in the week ended Sept. 16, the largest weekly inflow this year, according to ICI data. That followed inflows of $8.2 billion in the previous week and $12.1 billion in the week before that.

After last year’s stock market meltdown many investors began tilting their portfolios more toward bonds. They know that bonds are, in general, safer than stocks. The income bonds pay provides a cushion even if the value of the securities declines.

And bonds can rise in value -- generating capital gains – if market interest rates fall, because sliding rates boost the appeal of older bonds that pay higher fixed rates.

That’s what has happened in the corporate, mortgage and municipal bond markets, in particular, over the last two months: Market interest rates have continued to drop, pushing up prices of existing bonds.

The share price of the biggest bond fund of all, Pimco Total Return, closed at a record high of $10.91 on Thursday. The fund’s year-to-date total return (principal change plus interest income) is 12.2%. That’s less than what stocks have done, but it’s comfortable enough -- and that’s all many bond investors ask.

With so much new money favoring bonds, the temptation is to think that the crowd must be wrong. If market interest rates were to rise abruptly the rally in bonds would reverse, of course.

Yet few signs are pointing to higher rates. Inflation is subdued. The economy is reviving but it surely isn’t busting out. And the Federal Reserve again this week pledged to keep its benchmark short-term rate near zero indefinitely.

Conventional wisdom is that all of the money the Fed and the Treasury have pumped into the financial system will result in an inflation surge. But that’s a story for 2010 or 2011, or maybe even later, if it happens at all.

In the near term, the most likely negative surprise for bonds might just be that stocks continue to perform much better while bonds putter along. That’s the kind of disappointment most bond investors probably could live with.

-- Tom Petruno