Beware the bond bubble.
In their flight to quality, investors have poured some $100 billion into taxable bond funds this year alone; and that's after 2001's record inflows of $86 billion. Quality, though, is hardly synonymous with risk-free.
Treasuries -- considered the safest investment around -- are not immune from the economic principles that cause prices in all sectors to rise and fall. And when they rise too much, fall they must.
"Markets tend to overshoot," says Lisa Black, manager of TIAA-CREF's
Bond Plus fund. "In these uncertain times, investors are flocking to what they perceive is safe. But the concern we have is that people tend to buy high and sell low."
The bond market has outperformed the stock market for three years in a row and is on track for a fourth -- an almost unprecedented event, says Morningstar analyst Scott Berry. And as a result, "assets have just poured into the bond market," Berry says. "But investors shouldn't expect the returns we've had the past few years to continue over the next few years. People need to have realistic expectations."
Indeed, the concept seems obvious, but it warrants repeating: You
lose money in bonds. The same goes for bond funds. As interest rates rise, the net asset value of the fund decreases as its assets decline in value. Granted, if you hold a fund for the duration of its average holding's maturity (for instance, hanging on to a fund that invests in intermediate-term debt for 10 years) you will likely get back your principal, but there's no guarantee.
Bond yields are currently at 40-year lows. Perhaps most remarkable is that two-year Treasuries on Oct. 3 posted yields of 1.75% -- that's the same level as the federal-funds rate. Typically, two-year Treasuries trade at yields some 100 basis points higher than the fed funds rate.
"By bidding up the price of the two-year note and creating such low yields, the market is signaling to the
that it needs to lower rates," Black says, adding that economic indicators are strong enough that she thinks the Fed doesn't need to lower rates.
Even those skeptical about current economic indicators acknowledge that lowering the federal funds rate won't do much to stimulate the economy. "The Fed is out of bullets," says James Cusser, portfolio manager for Waddell & Reed's
Advisors Bond fund. "Lowering the rate won't make a difference if nobody's borrowing money. People are not requiring a lot of capital."
Gimme Gimme Gimme
The extraordinary demand has been fueled by several factors, all of which contribute to an environment that -- by most accounts -- is simply not sustainable.
The demand hasn't been limited to retail fund investors, though. Plenty of institutional investors have bid up Treasuries -- namely, government agencies such as mortgage lender Fannie Mae.
Mortgage refinancing has become something of a hobby for many homeowners. When people refinance their homes, they're essentially paying off their existing mortgage with a new loan. That exchange, though, creates a "duration gap" on the books of agencies such as Fannie Mae. The high rate of prepayment means that the duration of the agency's assets (the outstanding mortgages) are declining at a faster rate than the duration of their liabilities (the money that's needed to fund new mortgages). Fannie Mae has tried to compensate for that mismatch by buying Treasuries. In anticipation of Fannie Mae's increased desire for Treasuries, other investors have rushed in and bid up the prices.
Other less arcane reasons currently driving demand include a general nervousness over a war with Iraq, the stock market's anemic returns and the expectation that stocks have further to fall. Given the current economic climate, stocks should be trading at 10 times 2003 earnings, says Mark Kiesel, a portfolio manager with bond giant Pimco, whose
Total Return fund just surpassed Fidelity's
Magellan as the largest actively managed mutual fund. Instead, though, stocks are trading at 17 times 2003 earnings.
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It's the pathetic state of affairs in today's stock market that makes Kiesel think that the boom in bonds is sustainable -- at least for a little while. "Bonds have outperformed because they're a good opportunity," he says. "You can get five or 10-year Treasuries yielding 3% to 4%, mortgage-backed securities yielding 4.5% and corporate bonds yielding anywhere from 5% to 10%, depending on how much risk you can take on."
Quite unlike Treasuries, corporate bonds are trading at historically high yields and are supplanting the need for equities. "You'd have to be pretty confident that whatever stock you buy will return more than the yield on its bond," Kiesel says. "Especially since bonds are higher than equity in the capital structure of a company." In other words, corporate bonds are paying such high yields because of the risk premium attached -- but if a company goes under, bondholders have a claim on assets, whereas stockholders do not.
Even while claiming there's no bubble in the bond market, Kiesel acknowledges that Pimco has decreased its stake in Treasuries of late, in search of other risk-free assets with better yields. For instance, the fund has recently begun buying German AAA-rated bonds, which are yielding between 70 and 100 basis points higher than U.S. Treasuries.
"We're within 50 basis points of how low Treasury yields can go," Kiesel says. "But bond inflows need to be put to work somewhere. A lot of new money will be directed at corporates, mortgages and international issues."
Adding those to a bond portfolio that's underweighted in Treasuries, Kiesel expects that a diversified high-grade bond portfolio can earn 5% in the coming year or two.
Unfortunately, that passes for big gains these days -- whether we're in a bond bubble or not.