Bond Funds Hoard Cash Amid Economic Woes

BOSTON (TheStreet) -- The cash holdings of bond mutual funds are ballooning this year as mounting economic concerns keep managers from buying new debt, despite growing inflows from investors looking to avoid risk.

The average cash stake in the 1,623 funds tracked by Morningstar ( MORN) rose to 9.8% at the end of June from 9.1% at the end of 2010, or by about $243 billion, according to Morningstar data. The average bond fund's cash position was at 10.2% at the end of 2007 and 10.1% at the end of 2008 as investors sought to avoid risk during the recession.

Investors have been plowing money into bond funds this year, adding $92.8 billion through June 30, the biggest inflows of any fund category. Bond fund managers are taking in more money, but spending less of it on new debt issuances.

"There's been a lot of money flowing into taxable bond mutual funds, both institutional and retail (as a form of) risk aversion," said Todd Rosenbluth, a mutual fund industry analyst at Standard & Poor's.

"That money will get put to work eventually, but when you're buying bonds, you're going off of new issuance," so it's not like buying equities where the market is more liquid and so cash balances can build, he noted.

But there are a lot of other issues floating around that would likely give a fund manager pause before buying bonds right now.

For one, there's the continued debate over the potential raising of the government's debt ceiling limit as it approaches an August 2 deadline. If it doesn't there's the potential risk default which would have negative consequences for U.S. debt.

Standard & Poor's equity research team said it believes the limit will get raised while the ratings agency Moody's ( MCO) on Monday suggested the U.S. eliminate its statutory limit on government debt to reduce uncertainty among bondholders.

Another question is whether the government will, in essence, continue its quantitative economic easing program (QE2) in one form or another. And then there are the continued uncertainties over the European sovereign woes.

These concerns are stoking interest in bond funds, despite their paltry returns. The yield on a 10-year Treasury note is currently just under 3%. The Vanguard Short-Term Bond Index Fund ( VBISX), which tracks a riskier part of the bond market, yields just 0.8%.

Bill Gross, manager of the Pimco Total Return Fund ( PTTAX), the world's largest bond fund at $247 billion in assets, has less than 10% of the fund's holdings in Treasuries and Treasury Inflation-Protected Securities (TIPs), according to Morningstar, a clear bet against those securities.

But rising demand helped long-dated government-bond funds gain 4.5% in the second quarter, generating an average return of 2.3% this year, said Morningstar. Short-dated Treasury funds rose 1% for the quarter and intermediate-maturity Treasuries rose 2.4%.

The S&P 500 index is up 5.7% this year.

Overall, long-term mutual fund flows turned negative in June for the first time since December, as investors withdrew $4.5 billion from funds after May inflows of $22.6 billion.

"Risk-aversion reigned as investors pulled about $18 billion from U.S. stock funds in June to mark the worst monthly outflow for the asset class since the peak of the credit crisis in October 2008," said Morningstar.

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