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What Goes Up Comes Down: 2013 Sets Record for Bond Fund Outflows

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The Federal Reserve’s Open Market Committee announcement Wednesday that it would begin tapering its QE purchases led to record closes that day for both the S&P 500 and the Dow Jones industrials. As Barry Fennell of Lipper wrote in a commentary on Friday, the fixed income market “largely took the announcement in stride,” as bond investors “appeared to be at ease with the low-inflation, slow-growth environment that will now also be accompanied by a gradual and measured reduction in the Fed’s quantitative easing program going forward.”

Fennell pointed out that “significant capital gains distributions” and investors’ desire to harvest gains in their equity holdings may have “overstated flows data” for many equity and taxable bond funds in the week ending Dec. 18, when equity funds (excluding ETFs) had net outflows of $8.5 billion; equity ETFs had net outflows of $4.5 billion; and nondomestic equity funds (including ETFs) had net outflows of $0.4 billion. On the fixed income side for the week, muni bond funds had $1.7 billion in net outflows, and money market funds saw a whopping outflows of $31.3 billion.

For the full year, however, bond funds saw significant net outflows. TrimTabs reported Dec. 11 that year to date, bond mutual funds posted record outflows of $70.7 billion, breaking the previous annual high for outflows, $62.5 billion in 1994. In a statement, David Santschi of TrimTabs said that bond mutual funds had experienced outflows for “seven consecutive months after they posted inflows in each of the preceding 21 months.” Just since June, investors pulled $164.5 billion out of bond mutual funds, TrimTabs reported; three of the four largest monthly outflows from bond mutual funds have occurred this year.

For all of 2012, according to the Investment Company Institute, a net $304 billion flowed to bond funds, nearly tripling 2011′s net inflows to bond funds of $125 billion.

Just because end investors are pulling money out of bond funds doesn’t mean they shouldn’t continue to have a role to play in client portfolios, of course. In an interview Wednesday before the FOMC announcement that the Fed would begin tapering, Krishna Memani, the former chief investment officer for fixed income at OppenheimerFunds and now the firm’s CIO, argued that  “fixed income still offers income and protection in your portfolio.”

Even if rates rise in 2014, he said, “the bottom line from my perspective” is that we are “still a couple of years away from a cyclical rise” in rates. If clients are particularly interested in a “better risk adjusted profile,” that is more likely to come from “credit rather than duration,” he suggested.

In terms of returns, Memani believes that high-yield bonds are “definitely good, but loans are better than high yield.” For Memani, “loans are the best risk-adjusted trade in all of fixed income.”