It's hard to blame investors for retreating to bonds over the past two years.
During the 2007-2009 bear market, U.S. households saw their 401k's and other retirement plans shrink by more than $3 trillion -- around 35% of the pre-recession total.
Of this, $2.4 trillion came from stock losses. The more you had in stocks, the more you likely lost.
Combine that with the 2000-2002 tech crash -- and a variety of economic calamities, panics and cases of fraud -- and you get the worst-performing 10-year period in the stock market since the 1930s.
So despite the economy's return to growth in the summer of 2009 and the stock market's 91% rally from its low, shell-shocked investors have stuck with the perceived safety of bonds and shunned stocks.
According to Credit Suisse, a whopping 95% of newly invested money has flowed into bond mutual funds since the beginning of 2009. Now, bonds account for 38% of all mutual-fund assets -- which is where most nest egg dollars sit -- up from 24.4% in 2007 and 19.8% in 2000.
This safe-and-sane approach leaves us at least secure, right? Unfortunately not.
A very long rally in bonds is coming to an end; a huge correction could be in the offing. So this flight to safety has set up a lot of everyday investors for the next great 401k washout.
Still living in fear
This flight to bonds has been driven by uncertainty and fear: A September survey (.pdf file) of investors by the Investment Company Institute found that investors' willingness to take risk remains well below pre-recession levels and continues to slide among the under-35 cadre entering their prime savings years. The "safety" of fixed-income investments has almost become an obsession; a Morgan Stanley analysis of ICI mutual-fund flow data shows bonds are now more popular than stocks were even at the peak of the equity bubble in 2000.But like all bubbles, this will end badly for those who don't recognize it for what is.
The great bond bull market -- which accompanied the long decline of interest rates from a high of 22.4% in 1981 to nearly zero now -- is coming to an end as rates start moving higher. This was the subject of my most recent column, as well as columns from November (on the Fed's $600 billion "QE2" money-printing initiative) and September (on inflation). The drivers will be a shift in the supply/demand balance for money, rising inflationary pressures and faster economic growth. With 10-year Treasury yields at 3.4% now, analysts at Jefferies are looking for rates of 5% later this year, while Morgan Stanley is looking for 4%.
While those gains don't sound drastic, investors in long-term bonds will be handed large losses as duration -- the leverage that's implicit in long-lived fixed-income assets -- comes back to bite them. It's like buying stocks on margin; the potential gains go up, but so do potential losses.
Duration bolsters returns when rates are falling and bond prices are rising, as they were during the 2007-2009 bear market for stocks. It magnifies losses when things reverse.
Say you've invested in a 10-year bond that pays one payment at maturity (a "zero-coupon" bond with a 10-year duration), and interest rates are at 2%. Then, rates increase to 4%. Not a big deal, you might think. But it would cost your bond around 20% of its value. If the bond matured in just two years -- a shorter duration -- your loss would be cut to 4% for the same change in rates.
The flight has begun
The market is starting to do this math. Bond yields are up from 2.4% in October and a low of 2.1% in December 2008, pushing bond prices down. This has the so-called "smart money" moving out of bonds and into stocks.For the week that ended Dec. 15, 2010, bond funds tracked by EPFR posted their biggest outflow since 2008 and posted outflows in six of the final seven weeks of 2010. For November and December, equity funds took in over $51 billion -- barely enough to push their annual total into positive territory.
As a result, bond funds are getting hammered. The iShares 20+ Year Treasury Bond Fund (TLT, news, msgs) is down 13% from its high since August as economic double-dip concerns receded and the sovereign debt crisis in Europe faded. Over the same period, the S&P 500 gained 22%.
This sets the stage for a wipeout among overly cautious investors who fail to move away from bonds in time.
The catalyst is simple: Watch for 10-year bond yields to move up and out of their long, 30-year downtrend. If interest rates push to 4.5% by the end of the year, it would be enough to put an end to the bond bull. Remember that bond prices move inversely to yield, so as rates rise prices will fall.
And this could happen despite the Federal Reserve's desire to keep interest rates low. Unlike short-term interest rates, the Fed's ability to control long-term interest rates is dubious at best.
In fact, its efforts to bring down long-term rates via "quantitative easing" have been a complete failure. In both cases, back in 2008-2009 and starting again last November, interest rates climbed as the Fed pumped money into the system.
Unlike the stock wipeouts we've seen, there won't be an economic calamity to run away from. This time, an economic bloom will bring the pain as increased growth and higher inflation push interest rates up and bond prices down. This will be a new and uncomfortable experience for many who are already familiar with seeing losses due to recession and deflating bubbles.
The scale of the problem
Let's take a look at just how exposed households are to rising interest rates and a bond correction.As mentioned, 38% of mutual fund money is now in bonds. That's down slightly from a peak bond allocation of 43% in early 2009 -- which represented the highest bond allocation since 1995.
But it's poised to fall further: During the rising-interest-rate environment between the 1955 and 1980 bonds made up on average just 12% of mutual fund assets.
A decline to that level would see nearly $2 trillion pulled out of bond funds in favor of equities.
At the same time, investment in stocks has fallen from a high of 29% in 2000 to a low of 12.6% in early 2009, and just 17% in the third quarter of last year, as shown in the chart above.
Stock-based assets as a share of total mutual-fund holdings have fallen from 76% to 58% over the same period. These are depths not seen since the recessions of the early 1990s and 2000s.
That means a lot of households will suffer with bonds and miss the upside in stocks.
Continued: How to handle rising rates
More from MSN Money
- The end of the cheap-money era
- Top pros' top stocks for 2011
- 10 picks for the epic bull market
- Jim Cramer's top 10 Dow stocks for 2011
- Why it's safe to buy homes again
