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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.
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.
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 prompted our previous installment of 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?
The trend in responses was one of skepticism that bonds were as "safe" as some investment professionals have previously touted. Here is a collection of reader responses highlighting the distrust of bonds and other investments tied to government or state finances.
Don't Catch Bond Fever
Although there has been a large movement to bonds or bond funds since the beginning of the year, I don't think the move is over. It appears very likely to me that the stock market is likely to tank again this fall, which will push millions more to abandon stocks in favor of bonds. Then, just as the maximum number of investors and/or savers has their maximum exposure to bonds, then, and only then, will bonds tank, just as housing did [and is still doing], and as stocks did [and are still doing].
It seems clear to me that Treasuries and other government bonds cannot continue to be a safe haven for investment funds, but I have concluded that most investors [and even most investment advisers!] pay far more attention to track records than they do evaluating fundamental forces that act on the markets. Thus, a statement like, "The U.S. government has never defaulted on its obligations," has a lot more influence on people's investment decisions than a real assessment of the fundamental risks.
On a similar note, I saw recently where someone wrote regarding state and municipal bonds, that no state had defaulted on its bonds since Arkansas in 1934. On the face of it, this statement is probably true [I haven't researched it to be sure], but so what? The states are deeper in debt than they ever were back in the Great Depression, and absent a major bailout by the federal government, it appears to me to be inevitable that many of them are going to default in the near future. And after the way bondholders were treated in the General Motors bailout, I wouldn't be surprised to see them get hit pretty hard again, even if the Feds do ride to the rescue.
Regardless, after Treasuries collapse I suspect that a lot of people will remove any remaining money that they have in stocks or bonds and put it in cash, either in banks or under their mattress, just in time to be hit with a sudden jolt of hyperinflation that will actually take most of them effectively to zero. The fact that their debt will likewise be largely inflated away will mean little, since they will be left broke, bankrupt, and destitute, and very likely unemployed.
So in the face of this analysis, what am I doing? I am about 10% in speculative stocks, 20% in cash, 30% gold and gold funds, and 40% short, either in inverse funds, or holding puts on the Standard and Poor's 500 Index. The speculative stocks are an effort to hit a home run. The cash is available if I see another compelling opportunity. The gold is insurance, and the inverse funds and puts are to build my account so as to be ready to buy solid, blue-chip equities and/or growth stocks in six to 12 months, when they have been knocked substantially lower and everyone hates them.
And all of this is subject to change as real-time circumstances may change. If I see evidence that stocks really do want to head higher, then I will close out my short positions and take my loss, but so far, that doesn't appear to be the case. If the S&P hits 1130, breaking above the tops established in June and August, then I will cut way back on my short positions.
– Gordon F.
Bonds and Hidden Financial Evils
Sorry, no bonds for me! Gold is the only way to have safety and profit!
Why invest in bonds when the value of the U.S. dollar is losing purchasing power every month and the U.S. has hidden false interest rates and inflation? We all know inflation is alive and well, and it will come with a bang to those people who want to look on the bright side along with the Fed and believe in the Obama administration and its belief that it will just "take a lot longer to get the economic situation under control and the U.S. is moving in the right direction but ever so slowly."
This country is in serious trouble and unfortunately it will bring down or have great negative effects on countries like Australia, Canada and others that have currently strong economies and real interest rates that control inflation. The U.S. needs a change and the answer is not too print more dollars to support failed business and banks that created these problems because of greed and poor management.
Few Safe Havens Left
I no longer trust anyone with my efforts at wealth retention. Until I see some real fiscal responsibility in Washington, D.C., Wall Street and in the entire banking industry, I'm investing only in small graded gold coins and "survival silver" (35% to 90% silver content, circulated) where I can easily determine the value and not worry about anyone getting between me and the small savings reserve I have left.
Far too many people on "Main Street" that I know and work with in my own business trusted "professionals" and have seen their dreams of a decent retirement all but permanently destroyed.
"Cheated once, shame on them, cheated twice, shame on me."
– Thomas A.B.
Pulling Back on Bonds
I've been lightening up on some PIMCO corporate bond funds that have been paying out nicely, but I don't trust the market, thus pulling back; however, too soon since the fund's net asset value continues to rise. Maybe that's because – as the article suggests – of the huge influx of money into bonds. Also dropped GNMA since it seems that it is getting too close to subprime mortgages.
I've been selling off some equities; some at a loss since I believe the market will take another large down turn. Have some money in foreign denominations and plan to buy more. We don't have physical gold, but do have a gold/silver fund. I've been frantic about protecting our assets while the politicos and money manipulators are trying to take it away.
– Werner R.
The Path of a Debt-Driven Recession
The bond market will be higher by the end of 2011, with the ten year at about 1.8%.
Inflation will be 0% or negative for most of the next ten years.
U.S. consumers will continue to pay down debt, skip vacations and live within their money for quite awhile. Any spare money will go for taxes. People working will continue to see their paychecks drop. The same jobs paying $70,000 a few years ago are now paying $28,000.
Housing is currently overvalued by 30% – 40% against the affordability index. Real unemployment currently at 16.5% will get up to 25% or 30%. State bonds will increase in defaults over 2009's $580 million.
75 million baby boomers how in their 50s and 60s are underwater for retirement and money will continue to be pulled out of stocks into Treasuries. The purchasing power of Treasuries could be as high as 3% in some years (buy a TV today at $1900 or next year at $1400?). And the same with homes.
Past recessions were liquidity-driven, this depression is debt-driven, big difference.
Enjoy the summer of recovery! Or maybe the summer of 2022?
– William O.
No way on bonds! My safety area is first gold and silver, and next energy as our society needs it.
Gold, silver and oil are great, but what does one do when all your savings is in your corporate 401k, and you are limited to stock mutual funds and bonds? I'm 100% in a PIMCO bond fund.
The economy is not recovering so why put my money in stocks?
Skeptical of Uncle Sam
No way, Uncle Sam is a deadbeat. In time he will be paying interest on bonds or redeeming his I.O.U.s with more bonds only, or there will be complete default or at least extended dates for service.
The bond market may have some short-term upside, but not what could be called a long-term investment.
– "Fact Finder"
[Editor's Note: Thanks to all who responded to our previous installment of the "Question of the Week" feature regarding the U.S. bond market. Be sure to answer next week's question: Should the U.S. government implement more programs to help stabilize the housing market? Have the programs they have used helped or done more harm than good? Do we just need to let the housing market adjust itself and wait for a return to "normalcy," or will the domino effect of more mortgage defaults and housing price declines hurt the rest of the economic recovery too much to ignore??
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Thanks to everyone who took the time to participate – via e-mail or by posting their comments directly on the Money Morning Web site.]
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