Don’t count bonds out just yet

After four years of halting, nervous gains, are investors poised to bail out of bonds and lift the stock market to new heights?

The surge of money into stocks and stock mutual funds in January, especially in the United States, fuelled hopes that the so-called Great Rotation from bonds to stocks had begun. A closer look indicated that most of the money was coming not from bonds but from cash and cash equivalents that fearful investors had squirrelled away. Since then, commodity prices have cracked and stocks have pulled back from their highs.

But stock markets are forward-looking creatures, so they could rise again soon in anticipation of better days ahead.

"Certainly, if you think about the big picture, we've had a 30-year period in which bonds have been really good investments," said Robert Gorman, chief portfolio strategist at TD Waterhouse in Toronto. But those days are pretty much over, he added.

"One of the emerging trends we're just starting to see is a shift from pure bond funds to income funds," Mr. Gorman said. Such funds might hold a mix of, say, corporate bonds, dividend-paying growth stocks and real estate investment trusts, among other things.

At Mawer Investment Management in Calgary, clients are scaling back "ever so slightly" on their fixed-income investments because they are worried about rising interest rates, says Jamie Hyndman, director of strategic business development. (Bond prices fall when interest rates rise.) "People want the right amount of fixed income but not too much."

Investors are also tiptoeing back into global equity funds, concerned that the commodity-propelled Canadian stock market boom is ending, he said. The Mawer Global Small Cap Fund was up 29.5 per cent in the year to Dec. 31, compared with 15.6 per cent for its benchmark.

"There's an awareness that diversifying by geography is the right thing to do in a slow growth environment where Canada might not be the strongest," Mr. Hyndman said.

Allan Small, senior investment adviser at Dundee Wealth in Toronto, also sees an emerging trend to more foreign content. The Canadian market is dominated by resources, commodities and banks, Mr. Small noted.

"If you want exposure to technology, health care and retail, you have to invest outside of Canada."

Ahmad Dajani, vice-president of investments at the Bank of Nova Scotia, has seen a shift to shorter-term investments as people take a wait-and-see approach. Some investors are gravitating toward principal-protected notes linked to stock markets. "They're looking for potential without downside risk."

One thing that has not changed this year is people's tendency to contribute to their registered retirement savings plans mainly to get a tax refund, rather than as part of a long-term investment strategy, industry participants say. All too often, investors, paralyzed by indecision, park their money in a term deposit or short-term guaranteed investment certificate and forget about it. Many have not recovered from the dreadful shock of the 2008-09 market meltdown.

"There's a lack of long-term planning in RRSP investing driven by how badly people did in 2008," said Clay Gillespie, financial adviser and managing director at Rogers Group Financial in Vancouver. "They are less flexible in thinking about what to do in future, so they are not doing anything, just leaving it in cash. The amount of money sitting in cash and cash equivalents is huge."

In another shift this year, there's a preference for tax-free savings accounts over RRSPs, Mr. Gillespie said. "It's quite an eye opener seeing some people's opinions."

As for the Great Rotation, Mr. Gillespie sees no sign of it. If anything, people are taking less risk than five years ago, he said. Indeed, among younger people, the stock market holds little appeal.

"Their only experience of the stock market is that it has lost money," he said. He points to the U.S. market, which has been flat for the past decade. "That's forever when you are 25. To young people, the stock market is a waste of time because you lose money."

A nascent rise

The whoosh of money into equity mutual funds south of the border in January gave rise to hopes that the so-called Great Rotation from bonds to stocks was at hand. Turns out most of the money came from cash and cash equivalents (money market funds), a trend that is evident in Canada as well.

Balanced funds were the biggest beneficiary of the $879.5-million flow of savings out of mutual funds in January, statistics from the Investment Funds Institute of Canada show. Balanced funds had net sales of $4.1-billion in January, more than double $1.91-billion the previous January.

Still, the most recent statistics from the IFIC do hint at a nascent revival in stock funds at the expense of bond funds. Whether it is sustained remains to be seen.

Net sales of bond funds fell to $1.3-billion in January from $2.38-billion. As bond funds fell, stock funds gained – a marked change from a year ago. IFIC members reported net sales of stock funds of $272.5-million in January, compared with net outflows in both December and January of 2012.