Beware the Bond Bubble

Beware the Bond Bubble The hissing sound you are hearing may not be the final death call from the stock market, or more specifically the Tech Bubble bursting from January 2000, but may instead be the beginning of the Bond Bubble about to burst.

Investors have pulled money from the stock market and moved into taxable bond funds to the tune of around $100 billion this year alone; and that is on top of 2001's record pace of $86 billion.

In these uncertain and turbulent times, investors are flocking to investments they perceive as safe. The concept is known as "flight to safety". The problem here is they may very well get double-dipped on the volatility of investing, especially those that have taken the majority of the down side from the stock market and buying into the bond market on the high side. Bonds seem to be synonymous with safe to investors and they may not be totally aware of the risks associated with this particular asset class.

According to Morningstar, the bond market has outperformed the stock market for the past 3 years running and is on track to complete a fourth year which is unprecedented. Assets have poured into the bond market over this 3-year window. This is indicative of investors chasing returns and typically has a negative result. Asset management and allocation should include all asset classes with proper weightings to the classes that reflect the overall objective and risk tolerance of the investor. Moving to where the market is presently is not the most effective means of managing assets and typically leads to a whip saw effect in returns; you are hit on the downside of one market only to get hit again from the market you are chasing.

You can lose money in bonds and bond funds. When you buy a bond you are loaning money to an entity, corporation, government or municipality for a promise of repayment of the loan in the future as well as an interest payment on the money borrowed. The bond typically issues at a Par (face) value of $1,000 and pays a Coupon (interest) rate. The price of the bond changes as prevailing rates in the market change so the value of the bond, or bond fund, held in your portfolio moves inversely with interest rates. As rates increase bond prices decrease and vice-versa.

With rates as low as they are at present the only real long-term direction they can move at this point is up, bringing bond prices down with them.

Bond prices have soared this year: a symptom of investor anxiety about a recession that began in March 2001, the continued risk of further terror attacks and the likelihood of war in Iraq along with a traumatic plunge in U.S. stock prices. Meanwhile, bond yields, which move opposite to their price, have fallen significantly reflecting the low rate environment we currently have.

Bonds have an inverse relationship to interest rates and to some degree the stock market as a whole. If rates are low, bond prices (not their interest payments) are typically higher, but you have to keep this in the proper context in that lower interest rates have to be lower in comparison to the bond coupon. For example, if you purchased a 30-year bond at par ($1,000) 5 years ago and it pays a coupon of 7% then that interest payment to you does not change. The current market value and subsequent yield on the bond does change however based on where current interest rates are holding.

This same bond may have a "market value" of $1471 if current rates were to fall to 4% for an effective yield of 7.6%. Rates went down and the bond price and yield went up. If the opposite changes happen with rates going from the current low status we now enjoy to a higher lever, which is more likely than not, the price of bonds will start to fall. The bonds being issued now at much lower rates than before will lose market value as interest rates rise. It is a seesaw type relationship. If your intent is to hold the bonds until maturity and collect the income along the way this is not as important as watching your account statement fall in value due to changes in market valuation of the bonds.

This could not come at a worse time for investors, who have been pouring money into bonds and bond funds at a skyrocketing pace. More than $14 billion flowed into bond funds in September, according to fund tracker Lipper, and TrimTabs.com estimates that an additional $13 billion will go into bond funds in October.

Pimco said that its Total Return bond fund has swelled to $64.6 billion by the end of September, edging the Vanguard 500 Index and the Fidelity Magellan fund for the title of largest mutual fund.

The investors who are going to really get tagged here are those who were the last ones out of the equity markets, and finally got into fixed-income funds when Treasury yields were lower. Those individuals have taken big losses, and then have gone into another asset class that will likely give them more losses, although pay them a steady income stream in the process.

When risk aversion is declining, money will flow out of the safe-haven Treasury market into riskier assets'the opposite of the flight to safety.

The trick here, as always, is to attempt to position yourself for the long-term with positions created in various assets and asset classes. The typical investor is guilty of emotional trading and chasing returns, steadily getting burned in the process. Income positions should always be a part of one's portfolio; the weighting depends upon a multitude of factors including the overall condition or outlook for the economy and stock market.

Joe Montana, the former quarterback of the San Francisco 49er's, was once asked in an interview what was his secret to being a great quarterback. His response was basically that it was simple; he merely had to throw a football with a perfect spiral to a point down the field where the receiver would be when the ball arrived. If he was to throw the ball where the receiver is at present then only 2 things can happen. Either the throw would be incomplete or the other team would intercept it, either way it did not look good on his statistics. A similar philosophy should be adhered to when building a portfolio.

Advisor is a Registered Principal of and offers securities through FSC Securities Corporation (Member SIPC).