Bonds: not so scary after all?

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So much for that great rotation.

A year ago, as the U.S. economy started to pick up steam, there was a roaring consensus that the heyday for bonds was coming to an end. Stocks, strategists said, were where the big money could be made.

There's no question that it worked for a while. Investors who bought that theory made some big bucks, especially if they invested in U.S. equities. The S&P 500 is up about 20 per cent in the past year.

Here's the thing, though: despite that dynamic, bond returns haven't been horrendous. There have been some ugly moments, such as during the spring, when 10-year U.S. Treasuries re-priced upwards by over 1 percentage point. But the market has since calmed. In part, that's because fixed-income liquidity has dried up, especially for corporate and high yield bonds, so many investors have adopted a buy-and-hold mentality, as UBS strategist Matthew Mish noted.

Incredibly, retail investors are now moving back into bonds. September U.S. mutual fund flow data is now out, and last month three of the four highest net inflows went into bond and credit funds, according to Morningstar. Non-traditional bonds led the way, then high yield bonds, then short-term bonds. Institutional clients don't seem so scared either, considered how they plowed money into the Verizon Communication's record debt offering.

Given all this data, there's a growing counter-theory, one that hails the 'not-so-great rotation.' Last year Bank of America Merrill Lynch put out a report that called "The Bond Era Ends." Morgan Stanley's pushing back with its own report, titled "Great Rotation? Probably not."

The main gist, according to the International Financing Review: "The original BofA Merrill thesis hugely simplifies the demand dynamics of financial markets, from the investment constraints faced by pension funds and insurers to an aging Western population," .

Morgan Stanley worries that if institutions, which control 60 per cent of global assets under management, start cashing in on U.S. equity gains and the like, it "could outweigh much, if not all, of increased risk appetite from retail investors."

However, bonds aren't bulletproof, either. As UBS's Mr. Mish noted, credit spreads have a high correlation with the VIX index. If you haven't noticed, the VIX recently popped north of 20, yet spreads haven't really budged. This same situation has played out before, and the bond markets survived unscathed because the underlying market fears over events such as the Italian elections in February were short-lived.

But drawn out confidence-draining events, like the U.S. debt downgrade in the summer of 2011, ultimately hit spreads. If the U.S. can't find a solution to its political gridlock that lasts longer than a few weeks, what will happen to bonds?