The marginal investor in bonds might be increasingly information insensitive. Last week’s inflation surprised to the upside and there are good reasons to think it will continue to move higher. Nominal GDP growth this year is expected to be around 10%, crude oil prices are steadily ticking higher, and the Administration wants trillions more in spending. Yet bond yields remain range bound. In a prior post we discussed classes of constrained investors who are buying bonds at negative real yields because their alternatives are even less attractive. In this post we describe another captive bond investor, the $1.6t Target Date Fund complex. Then we show that they are just a microcosm of a broader rebalancing story where the wealthiest generation on earth is buying more bonds as they retire. These flows appear agnostic to economic fundamentals and can potentially push bond prices beyond any reasonable valuation.
What Are Target Date Funds?
In the U.S., white collar workers have the option of automatically contributing a portion of their paycheck into company sponsored retirement funds. An increasingly popular fund choice are Target Date Funds, which are offered in vintages that correspond to expected retirement dates. Funds with far off retirement dates have high equity allocations that are mechanically rebalanced towards bonds (corporates and sovereign) as the retirement date approaches. For example, a 2045 Target Date Fund targets a retirement date 25 years from today and would be heavily invested in equities today but gradually rebalance towards bonds over time. These funds take in money and invest according to their preset allocation formula, regardless of inflation or earnings or any other economic fundamental. They literally have no choice but to keep on buying.
Recent filings show that their Target Date Fund assets have grown to $1.6t, with the bulk of their holdings concentrated in vintages that are in the process of steadily reallocating into bonds. (For more information on these flows see this post.) These funds will continue to buy bonds both due to gliding target allocations over time and additional inflows from periodic paycheck contributions. A buoyant equity market also increases bond purchases as each fund will have to sell equities/buy bonds to maintain current allocations. This all mechanically puts a bid under bonds at any price.
Rebalancing Flows Will Continue to Grow
The Target Date Fund complex is a relatively small part of the $34.9t U.S. retirement system but it illustrates a broader point. Retail investors are taught to shift their asset allocation away from equities and into bonds as they age. Bonds are perceived as safe, which is not an unreasonable assumption given recent decades of stable inflation. Data on Independent Retirement Accounts, an unconstrained $12t subset of the U.S. retirement system, shows that the average retiree holds close to quadruple the bond allocation as an average investor in their 30s.
The U.S. baby boomers are the wealthiest generation in the history of the world and they are in the process of retiring. They appear to be following conventional wisdom and rebalancing into bonds by their own volition like the mechanical behavior of Target Date Funds. This is suggested by the persistent equity mutual fund outflows alongside the persistent bond mutual fund inflows. (Note: Some of the equity mutual fund outflows are to lower fee equity ETFs). Baby boomers are just beginning to retire, so these rebalancing flows could increase significantly in the coming years.
Are Bonds Still Smart?
A long standing view of the investor community is that bonds are smart, while equities tend to be much more emotional. Enormous efforts are expended to extract “market based expectations” on growth/inflation etc. from bond prices. This could work if other market participants are also expressing fundamental views in their purchases and sales. But that’s obviously not the case. Bank HQLA portfolios are buying bonds because it’s better than IOR, retail is buying bonds because they are retiring, and of course the Fed is buying $120b a month of bonds because. These add up to significant flows that are made without any view on economic fundamentals. The bond market cannot “see through” inflation when so many bond buyers are blind. The market can only be as smart as its participants.
Retail buying has sent share prices of many profitless companies soaring because they believed they were good investments. Retail investors now believe that they should be buying bonds as they age. They are likely as oblivious to bond valuations as they are to the valuation of TSLA. Their behavior has the potential to keep bond prices rising over the coming years even in the face of rising inflation, at least until their belief system changes. Bonds can behave like meme stocks.