Ongoing stock market worries and a string of discouraging economic reports have imbued the U.S. bond market with "safe-haven" status. The upshot: Investors have poured record amounts of money into bond funds.
"It is hard to pick up the newspaper and see anyone optimistic," Francis Kinniry from The Vanguard Group Inc., told Bloomberg News. "The problem is there is not a lot of good news on the recovery front and that translates in people's mind to poor capital markets."
Bond funds for the past two years have seen inflows almost as high as stock funds did during the Internet bubble, according to the Investment Company Institute (ICI). From January 2008 through June 2010, outflows from equity funds totaled $232 billion, while inflows to bond funds hit a staggering $559 billion.
Bank of America (NYSE: BAC) Merrill Lynch's Global Broad Market Index, which tracks more than 19,100 bonds with a market value of $37.6 trillion, is on track for an annual return of 10.2% – the best return since its creation in 1997.
Investors are spending billions in the bond market even as yields reach record lows. Investment-grade U.S. corporate debt yields hit a low of 3.79% last week and two-year U.S. Treasury yields fell to less than 0.5%.
But are these seemingly "safe" investments as protective as investors believe they are?
Analysts are warning investors there's a "bond bubble" growing that will soon burst, and they should be prepared for a dot-com-like collapse.
"In 2000 or late 1999, we saw massive amounts of money going into the equity market at just the wrong time," said Citigroup Inc.'s (NYSE: C) chief U.S. equity strategist Tobias Levkovich. "I feel the same way when I look at the money going into bonds."
Investor pessimism toward stocks rivals the optimism on equities a decade ago, and when the Internet bubble burst in 2000 the Nasdaq Composite Index began a slide that would see it drop by 74% from its peak (to underscore just how ruinous speculative bubbles can be, the Nasdaq even now remains 58% below its March 2000 peak of 5,048.62).
Some analysts fear that the powerful flow of cash going into bonds is creating a similar bubble-like dynamic for fixed-income securities – and especially U.S. Treasury bonds.
The yield on non-inflation-adjusted Treasury bonds is down to 1%, meaning they're selling at 100 times the projected payout – which is akin to tech stocks selling at more than 100 times earnings.
Bond investors are also ignoring two important risk factors:
- An interest-rate increase by the U.S. Federal Reserve.
- And the interest-rate pressures that spin out of an inflationary spiral.
When U.S. interest rates inevitably rise from their 50-year lows, they'll push down bond prices, meaning investors will watch as the market price of their holdings drops down below what they originally paid for the bonds.
And with yields hovering at record lows, any small inflation increases could lead to investment losses on an inflation-adjusted basis.
Fund managers are trying to lure people back into stocks, with little luck. Analysts think it could take a major market rally to turn the tide back toward stocks. Investors want to see more stability before getting back into that part of the financial market – but that hesitation could cause investors to miss out on the big, initial gains when the stock market does reverse course and renew its advance.
As Fidelity Investments' John Sweeney told Bloomberg: "Someone who is waiting for stability is likely to miss out on the upside."
This brings us to the latest Money Morning Question of the Week: Are you seeking investment protection in the bond market? Have you adjusted your strategy to involve fewer equities and more bonds? Do you think there is a bond bubble forming – similar to the dot-com bubble – that will take some investors by surprise? If you haven't dove into fixed-income securities, then what stocks or other instruments have you included in your portfolio for safety measures?
Send your thoughts, questions and concerns to firstname.lastname@example.org.
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News and Related Story Links:
Investors Shake Up Funds With Record Bond Love Affair
Bond Funds Gain Cash Like Stocks in Dot-Com Era: Credit Markets
- The Wall Street Journal:
The Great American Bond Bubble
- Money Morning News Archive:
Question of the Week Feature