Long-Term Bonds Could Be in Jeopardy

NEW YORK (TheStreet) -- As many investors have shunned stocks and turned to long-term fixed income to park their investment dollars, the safety of long-term bonds may be in jeopardy.

The first reason the long-term bond market might be in trouble is because prices are being inflated. With concerns over the overall health of the global economy, the burst of a housing bubble which led to a financial crisis and unemployment levels remaining at stubbornly high levels, numerous investors are shunning risk and turning to long-term bonds. In fact, over the last year, net inflows into fixed income investment tools have outpaced net inflow into equities by nearly tenfold. According to the Investment Company Institute, bond funds witnessed $375 billion of inflows in 2009 and the trend is continuing in 2010, with an estimated $380 billion to pour into bond funds. This in turn, has pushed long-term bond prices up.

A second factor that could be detrimental to long-term bonds is the likely rise in interest rates in coming years. Granted, economic slack, low inflation levels and stable inflation expectations will likely enable the Federal Reserve to maintain its target rate at record low levels through 2010 and even into 2011. But the Fed will eventually have to tighten rates to reduce its balance sheet and normalize its engagement with financial markets. This will make bond trading less attractive and will likely hinder bond values.

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A third force that could hinder long-term bonds is inflation. With the U.S. federal deficit surpassing the $1 trillion mark, the Fed likely will have no other choice than to print dollars and increase money supply. If, and when, this happens, increases in the Consumer Price Index will eat away at the yields and real returns on bonds.

Lastly, a massive selloff could damper the long-term bond markets. This could eventually force fund managers to sell bonds to meet redemptions, enhancing losses for other bond investors.

Although a bubble appears to be forming in the long-term bond markets, with the proper exit strategy and shorter-term bonds investors can diversify a portfolio and generate a little extra income. Some possible bond plays include:

• iShares Barclays 1-3 Year Treasury Bond(SHY), with a yield of 1.35% and 41 holdings with an average duration of 1.94 years. SHY closed at $83.85 on Monday.
• Vanguard Short-Term Bond Fund ETF(BSV), which has a yield of2.5 % and has 1,178 holdings with an average maturity of 2.8 years. BSV closed at $80.54 on Monday.
• iShares Barclays TIPS Bond(TIP), which has a yield of 3.56% and 29 holdings with an average duration of 4.15 years. TIP closed at $106.06 on Monday.