The action in the equity and bond markets so far in 2011 can be characterized by what I call a sort of “nervous uncertainty.” Let’s face it, we’ve had a lot of cause for worry, and we’ve had a lot of reasons to be encouraged. On the bond front, that nervous uncertainty has translated into a big surge in cash holdings among bond mutual funds. Apparently, bond fund managers aren’t in any hurry to purchase new debt, and that comes despite the fact that bond fund inflows are on the rise.
According to mutual fund research firm Morningstar, the average cash stake in the 1,623 funds the company tracks rose to 9.8% at the end of June from 9.1% at the end of 2010. In dollar terms, that’s about $243 billion. The average bond fund’s cash position was at 10.2% at the end of 2007, and 10.1% at the end of 2008, according to the data.
Meanwhile, investors have been funneling money into bond funds in 2011, adding some $92.8 billion through June 30. That’s the biggest inflows seen in any of the fund categories Morningstar tracks. In other words, bond fund managers are raking in the cash, and essentially hoarding it.
So, the logical question here is why aren’t bond fund managers investing in new debt right now?
Well, for starters, we can blame that debt ceiling debate for at least some of the uncertainty. Although I am not sure how to quantify this, I suspect that no bond fund manager wants to get caught with his guard down if the unthinkable does happen, and if the powers that be in Washington drive the nation into default.
Another reason why bond fund managers aren’t gobbling up new debt is the possibility of a credit rating downgrade. Such a downgrade has been threatened by both Moody’s and Standard & Poor’s, and though I suspect that we are in do danger of a downgrade here, the mere discussion of such a negative turn of events for the bond market is understandably spooking bond fund managers.
Then there’s the issue of the Federal Reserve’s follow-up policy to quantitative easing, part 2, or QE2. Will we see another round of money creation in some form or another, and if so, what will be the impact on the U.S. dollar and U.S. Treasury bonds? Nobody knows for certain, and this uncertainty is keeping cash on bond fund books.