Are Bonds A Safe Haven?

Fixed income ETFs dominate recent product launches. But is this a reassurance, or a warning sign?

Remember the flurry of emerging market ETFs being launched a year ago?  It wasn’t so long ago that “frontier markets” were the next big thing, and we saw trackers appearing to enable investors to reach equity markets in Vietnam, Kuwait, the UAE, Nigeria, Pakistan and Kazakhstan, to name just a few. Investors who caught the frontier bug have taken a hiding – the db x-trackers S&P; Select Frontier ETF is down 70% from its inception in January last year, for example.

It’s easy to be wise with hindsight, of course. But this case surely illustrates a broader point, which is that it pays to be very sceptical of the “flavour of the month” in investment.

In their defence, ETF issuers argue that they are only giving their investor clients what they are asking for, when launching new funds. But when clients are apparently all asking for the same thing at the same time, it might be worth wondering if they are having one of the periodic bouts of group insanity to which we are all prone.

So if a year ago London taxis were plastered with ads recommending ETFs on Indian, Chinese, Gulf state and Russian equities, in hindsight a warning sign for emerging market investors, perhaps now it’s worth being a little sceptical of the fad for bond, money market and inverse funds.

As an entirely non-scientific illustration of this, the db x-trackers site front page features a banner ad highlighting the fund’s range of inverse ETFs, with the logo “take advantage of falling markets”. The iShares UK site highlights the firm’s latest fixed income ETF launches. A report yesterday from the German stock exchange pointed out that the inverse DAX and inverse DJ Euro Stoxx ETFs were the most heavily-traded funds during the previous week. And money market ETFs continue to soar in size, even as the interest rates on offer have declined to almost nothing – the combined assets of the db x-trackers EONIA money market and Lyxor Euro Cash EONIA ETFs have reached €9 billion in little more than a year.

However, while money market ETFs should at least protect capital in nominal terms, albeit with the prospect of almost no return, and inverse ETFs should probably be seen primarily as a short-term trader’s vehicle, what about the current appetite for bonds?

With bond yields in the major markets at or near multi-year lows, the prospects for further capital gains are very limited, while the income return offers little compensation for currency and inflation risks. Tim Bond of Barclays Capital, in his recent research note “The Lost Decade” forecasts a sharp reversal (to higher yields and lower prices) in the US and UK bond markets over coming years, based on demographic trends – particularly the fiscal strains from an ageing population, with lower tax receipts and a return to inflationary pressures.

It’s worth adding that Bond is not particularly bullish on equities, foreseeing several years of low price/earnings ratios. However, of the two asset classes, he clearly favours equities to bonds, and sees an imminent reversal in the multiyear trend ofoutperformance of shares by fixed income.

So is the current spate of bond ETF launches a top-of-the-market warning sign? And should investors seeking a safe haven be putting their money elsewhere, even in equities?

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