Sunday, November 28, 2010

Bonds not looking so attractive

Bond investors avoided the ax and didn't wind up as the main course on anyone's Thanksgiving dinner table last week.

But a year from now, things could be different.

The bond market has been safe and secure for so long that investors could run around the farmyard and throw money at bonds with little chance of harm. Those old goats in the stock market, outside the corral, always faced the danger of getting dragged off by a wolf, but not bond investors.

At least that's been the thinking for years, as bonds benefitted from a lengthy trend of lower interest rates and mild inflation. But the protective pen that has sheltered bond investors doesn't look so secure anymore.

William Gross, managing director at California investment firm PIMCO, lately has warned of the "end of a great 30-year bull market in bonds."

Considering that Gross and his team oversee about as much bond money as anyone and have a vested interest in seeing bonds perform well, that's a caution worth heeding.

Roy Papp of L. Roy Papp & Associates, one of Arizona's more successful long-term investors, describes the situation for bonds as among the most treacherous he's seen in a career spanning five decades.

"Economic conditions around the world will improve, particularly in the U.S. and Asia," Papp said. "As that happens, prices on bonds will go down."

He now views stocks as "considerably" more attractive than bonds.

The portfolio managers at Ariel Investments in Chicago recently declared that bonds had reached "bubble territory."

In their view, three traits are characteristic of bubbles, and the bond market is showing signs of all three now.

The first is a surge of new money that inflates prices. Mutual funds that hold bonds have attracted more than $600 billion in net new cash since the start of 2009 and now are in their 23rd straight month of inflows.

By contrast, investors on balance have pulled money out of stock funds in each of the past three years.

The second is a tendency for prices to climb into unchartered territory. With bonds, this is usually described in terms of yields, which move inversely to prices. The recent numbers portray investors as willing to accept almost nothing in return for the privilege of owning bonds. Case in point: The government sold two-year Treasuries yielding just 0.4 percent in late October.

"When judged against historical valuations, bonds are in nosebleed territory," Ariel wrote in its commentary.

The third warning sign is a pattern of risks and returns getting out of whack. As evidence, Ariel cites yields that are now so low as to provide virtually no cushion in the event inflation rises even modestly.

Ariel adds that bond-market volatility could be worsened in the next downturn by the rise of Internet trading and easy-to-exit exchange-traded funds - neither of which was around during the last bond bear market.

Somewhat-naive investors often dismiss the riskiness of bonds by noting that they can recoup their principal provided they're willing to hold to maturity, regardless of what happens to interest rates.

That's true, assuming the issuer doesn't default. But there's still an opportunity cost in the sense bondholders would be stuck with an unattractive, below-market yield in the meantime.

In other words, in a rising-rate environment, investors must pick their poison: Sell their bonds and take a loss, or accept a below-market yield until their bonds mature and proceeds can be reinvested at higher, prevailing interest rates.

The point of all this isn't to scare investors into making rash decisions but to nudge them to prepare for some unpleasant possibilities, sooner or later.

In a diversified portfolio, it's difficult to avoid bonds altogether. It's also true that certain types of bonds and bond funds, such as high-yield and foreign debt, aren't as sensitive to U.S. interest-rate changes and might hold up well if rates jump.

But these alternatives also tend to be more risky than the plain-vanilla municipal, high-grade corporate and U.S. government bonds that most income investors favor.

If you have jumped onto the bond bandwagon, it's time to consider how you might get off if the 30-year bull market is indeed nearing an end.

Or as Gross put it in a recent bond-market outlook: "Run, turkey, run."

by Russ Wiles The Arizona Republic Nov. 28, 2010 12:00 AM



Bonds not looking so attractive

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