This article originally appeared on on 26 August 2013.

An inflection point occurs when the slope of a curve changes from plus to minus or minus to plus.

Financial markets are populated with inflection points. They mark directional changes in trends that can be sharp or gradual, short or long, trivial or consequential. One of the keys to successful investing is the ability to identify inflection points and predict whether underlying trends will accelerate, reverse or level off.

Federal Reserve Chairman Ben Bernanke’s talk of tapering on May 22 triggered an inflection point. His comments dramatically boosted interest rates, increased equity price volatility and influenced investors’ risk and asset preferences.

The jump to higher interest rates has, of course, resulted in losses for most bond investors and encouraged outflows from the asset class. It also has raised concerns about further rate hikes. Yet there are reasons to believe that over the secular horizon, flows into bond funds will turn positive. This inflection point will likely form part of an S-curve as investors return to bonds.

To understand why, it is essential to start with acknowledging that the past four years have been an extraordinary period. More than $1.2 trillion has flowed into U.S. bond funds since 2009, an annual pace nearly twice that of the prior decade. Remarkably, there appeared to have been no diminution of demand right up to May, when the talk of tapering began in earnest. The subsequent reversal was dramatic, with investors, led by individuals rushing to the exits, having withdrawn $75 billion in June and July alone.

Most certainly sentiment has turned since May 22. In the aftermath of the financial crisis, the media – which play a large role in setting the tone of the markets and the psyche of investors – went from being cheerleaders for bonds, stressing their virtues and role in maintaining a diversified portfolio, to romancing the notion that bonds are riskier than stocks.

The case for bonds
Yet there are factors – from sentiment to math to demographics – that suggest bond flows will bounce back.

First, while the media may have succeeded in sullying sentiment, their message that bonds are riskier than stocks is untenable. The measure of the price sensitivity of a bond to a change in interest rates is duration; it describes the direct relationship between a bond’s price and the level of interest rates. It is a cash-flow-weighted measure of time. In general, the longer dated the instrument, the greater is its price sensitivity to changes in interest rates.

But stocks also are sensitive to changes in interest rates – although significant uncertainty around dividend payments and terminal values makes the link between prices and interest rates less direct and reliable for stocks than bonds. As interest rates rise, these cash flows (from dividends and terminal values) are discounted at higher rates, depressing their net present value and exerting downward pressure on current stock prices. There is considerable logic (and academic literature) that suggests that stocks could be even more sensitive to interest rate changes than bonds in the long run. If rates continue to rise over a sustained period of time, stock prices will most certainly be affected, too.

What’s more, asset class attributes make bonds intrinsically more stable than stocks. Equity ownership entitles shareholders to a pro rata share of the residual cash flow and assets of the underlying business. Bonds, on the other hand, are higher up in the capital structure. They are a high priority corporate obligation to pay interest and principal on a timely basis and confer a claim on assets of the company. Thus, from a cash flow and credit perspective, to suggest that most bonds are generally riskier than stocks is not sensible.

Historically, bonds have been more stable than stocks. During the past 25 years, the worst calendar year for the bond market (as measured by the Barclays U.S. Aggregate Index) was 1994, with a 2.9% decline. By contrast, within the same period, U.S. stocks fell 38% in 2008. Even with 10-year U.S. Treasury yields having risen by 96 basis points from the start of the year through August 20, the bond market, as measured by the total return of the Barclays Aggregate, lost only 3.26%.

Who’s buying now?
Individuals may have been rushing to the exits, but many of America’s largest corporate pension funds and insurance companies have been buying long-dated bonds. The long maturities may help to de-risk their portfolios over the long-term, since these portfolios tend to have liabilities that can extend decades into the future.

We expect individual investors will eventually follow suit, once more becoming net investors in fixed income. Even if rates continue to rise, they would likely do so more gradually from here rather than suddenly spike. Moreover, U.S. Treasuries make up only one aisle of a much broader global bond supermarket. Active bond fund managers can sift through a wide range of bond sectors and deploy various strategies for sources of value even while rates are rising.

Secular forces also point to increasing demand for fixed income and the steady income it can provide. Demand will grow from the rapidly increasing numbers of cash-hungry retirees in developed countries and the burgeoning numbers of wealthy individuals in emerging economies. These trends will only be enhanced by the ongoing redefinition of the social contract over who will be responsible for the financial security of individuals in their old age. As rates reset at higher levels, yields will likely increase, enhancing the opportunity for bonds to provide even more attractive return and income.

Though it is easy to get caught up in the fear and greed that can propel markets to extremes and create unwelcome volatility, investors should not lose sight of their financial goals or the basic precepts of investing. The journey to financial security is a long one. It is full of bumps and turns … and the occasional inflection point.

The Author

Douglas M. Hodge

Chief Executive Officer

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Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. Equities may decline in value due to both real and perceived general market, economic and industry conditions. The value of most bond strategies and fixed income securities are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and more volatile than securities with shorter durations; bond prices generally fall as interest rates rise.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2013, PIMCO.