Avoiding a Bond Market Bubble
A financial bubble is like watching a tornado:
-- You see it far away, you discuss its seriousness with others and you hesitate just a moment to make sure that it really is what it seems.
-- Then it completely overwhelms you.
A bond market bubble, though still a hazy prospect on the horizon in 2010, represents the latest risk to have potentially destructive consequences.
Interest rates are at historic lows and bond prices at historic highs, but at some point rates are certain to rise again. Many investors who rushed into bonds to escape volatile stocks and low-yielding cash investments are unaware that rising rates always hammer existing bond values.
That's a serious problem for first-time bond investors knee-deep in the stuff but lacking the hindsight during their investment lives of a protracted period of declining bond values.
"Getting into the bond market now is a little like buying at the height of the Internet bubble," warned
From 1985 through 2009, bond-fund returns were negative in only 1994, 1999 and 2008, their declines less frequent and less precipitous than the down years for stocks during that same period, according to
Ease up on fixed-rate investments for a while and, if you're heavily into them, take time to diversify your holdings. If you do go into bonds, stick with shorter-term maturities of three to five years that let you to wait out volatility. They won't be as hard-hit by rising rates as long-term bonds.
"Most investors are lemmings, with more money going into bond funds last year than the previous 10 years combined and the pace slowing very little in 2010," marveled
The mass exodus out of low-return certificates of deposits and money-market funds to the higher yields of bonds is understandable, Cohen acknowledged. Yet she worries about how knowledgeable new bond investors really are.
"When this bond market turns--and it will turn--it will be ugly," predicted Cohen, who manages bonds for individuals. "It's not going to happen today, but it will happen at some point down the road that is not too far off."
That warning is primarily for bond newbies.
"The investors who got spooked, wanted out of stocks and loaded up on the bond market are the ones I worry about," Williams added. "Most investors think bonds are safe and will protect their money, but interest-rate risk is an issue that they just don't understand."
There's currently a lot of fear in the markets with investors worried about everything, which results in "hair-trigger responses" to events, she said. That's not a time when you make intelligent choices.
Make the broad assumption that interest rates are going to go up, said
The big question is when they'll start to go up. While it hasn't happened yet, the first hint will likely be serious talk about inflation, he said. That would indicate that the economy is starting to improve and capital will be moving from bonds into other investments offering greater returns.
"I don't know that we're in a bubble, but clearly bond prices are at historically high levels because interest rates are at historically low levels," noted Ferrara. "There is no reason to panic and sell out of bonds now, but burying your head in the sand and saying you'll just ride it out when problems develop will be pretty difficult."
Individual bonds have a final maturity date and you know what the income stream and call date will be. Bond funds, on the other hand, offer professional management, liquidity and diversification of bonds.
"A bond fund works better for someone with
Treasuries have always been the safest fixed-rate choices; municipal bonds also have had a good reputation, though pension problems have impacted some of them; and A-rated corporate bonds are good investments that often represent companies in the financial sector, Williams explained.
A sensible mix of stocks and bonds remains the best bet for bond-bubble avoidance.
"Typically, by the time the Dow goes up 1,500 points, or something like that, investors decide to shift from bonds to equities," concluded Ferrara. "At that point, their bonds will have decreased in value and they'll have missed the upward rise in equities."
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