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Are investors buying bonds at just the wrong time?

Are investors buying bonds at just the wrong time?

The latest fund sales figures from the Investment Association tell a familiar story: bond funds were yet again the bestsellers, as they have been for the last six months, enjoying around three times the inflows of equity funds in November.

Against the backdrop of rallying markets, that's perhaps no surprise. Investors have been keen to lock in some of the gains from stellar stock market performance over the last 18 months by opting for the perceived safety of fixed income.

But they are piling into bonds amid heightened fears for the asset class, with yields having spiked this week and bond guru Bill Gross declaring a 'bond bear market'.

The bond market sell-off was sparked by relatively innocuous news from the Bank of Japan, which made small reductions to its monthly purchases of government debt.

But the reaction this provoked highlights how nervous investors are about the withdrawal of central bank support for bond markets as quantitative easing efforts are tapered. 

Yields on government bonds, which move in the opposite direction to prices, jumped. US 10-year treasuries are currently yielding 2.55%, around the highest level in 10 months.

While some, like Gross, have been quick to herald this as a warning sign, it's worth noting that commentators have persistently warned of the looming end to the bull market in bonds,  while yields have continued to grind lower, and prices higher, for the last 30 years.

Just look at Gross' own record with predictions. As Laith Khalaf, senior analyst at Hargreaves Lansdown, highlighted, Gross warned in 2010 that gilts were resting 'on a bed of nitroglycerine' when yields were three times higher than they are today. 'To be fair, he wasn't alone, and hindsight is a wonderful thing,' said Khalaf.

Yet it is still difficult to see an easy path to returns for bonds as central banks around the world begin to cut back on their bond-buying stimulus programmes and, however tentatively, begin to raise interest rates. Higher interest rates are generally bad news for bonds as they eat into the value of their coupons.

When yields are at as historically low levels as they are today, the problem is even more acute.

'It's hard to fathom why bond funds have gained such popularity at a time of rising inflation and tightening monetary policy, both of which make wringing returns out of an already fully-priced fixed income market look like an uphill struggle,' said Khalaf.

He suggested portfolio rebalancing, with investors banking some of their profits from the equity rally, as a possible explanation.

While in more conventional markets this form of portfolio derisking would make sense, Karen Ward, chief market strategist for Europe and UK at JPMorgan Asset Management, argued it could backfire.

Despite the strong rally in equity markets, share valuations hadn't actually moved much over the last year, she said, with stock market gains having been powered instead by improved earnings.

'There has been a lot of nervousness given markets performed so well last year. It feels a little bit euphoric,' she said.

'[But] prices aren't rising on hopes of great future earnings. They are largely rising on realised gains.'

This has been powered by the ninth year in a row of global growth, and Ward argued a tenth was on the cards, especially should productivity revive, driven by a rise in corporate investment. A plunge into recession, she said, was not among the most imminent risks to markets.

'I'm much more worried about inflation than immediately running into some recessionary risk,' she said. 

'And if you're worried about inflation, it's difficult to see why you would derisk to cash or to fixed income at this stage.'

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