(01/27/11) What to Do Before the Bond Bubble Bursts

The last two years have seen the biggest boom in bond investing in our lifetimes. Investors, fleeing the ravaged stock market, have poured hundreds of billions of dollars into the presumed safety of bond funds.

From January 2009, we saw 22 consecutive months of inflows into bond funds, according to the Investment Company Institute, an astonishing $643.4 billion in all.

But starting last November, nervous investors began to pull money from bonds—mostly municipals—amid fears about state and local governments' finances. Outflows from munis have persisted into January, but money has continued to trickle into corporate bonds, the mainstay of the 2009-2010 bond boom.

And now many investors who've just made a big bet on fixed income are worried about getting caught on the wrong side of the trade yet again.

The rumblings apparently got loud enough that George U. (Gus) Sauter, chief investment officer of The Vanguard Group, the largest US bond mutual fund manager with $413.6 billion of fixed-income assets as of December 31, posted a cautionary message on the company's Web site.

“I'm increasingly worried that people aren't aware of the risks in the bond market,” he said.

“The problem is that when you're at historically low rates, as we are now, … yields aren't likely to go significantly lower, and at some point when the economy does strengthen, they're likely to push higher.

“If rates move sharply, we could experience a year or more where investors receive a meaningfully negative total return from bonds. That's certainly happened in the past. And it's very possible, if not probable, at some point in the future,” he concluded.

Vanguard was at pains to call this “education,” not the dreaded “market timing.” But the message couldn't be clearer: Fasten your seat belts; it's going to be a bumpy ride.

And it's a ride for which bond investors simply aren't prepared.

A Quiet Bubble, but a Bubble Nonetheless

“Surveys have shown that many bond investors do not understand that … if you have a long-maturity bond and rates increase, then prices fall,” says longtime bond investor Richard Band, who edits the Profitable Investing newsletter. Investors have moved en masse out of stocks, whose risks were amply demonstrated in the 2008-2009 market meltdown, and toward the boring, regular coupon payments of bonds. Now, Sauter and others warn that the modest returns they were counting on may not be in the bag, either.

This shouldn't be surprising, given the huge run we've seen. Still, Francis M. Kinniry Jr., a principal in Vanguard Investment Strategy Group, told me he doesn't “believe at all there is a bubble in bonds. We do not see a [popping or a bursting] in fixed income.”

According to Vanguard's research, “the worst 12-month return for US bonds since 1926 was -9.2%, while the worst 12-month return for U.S. stocks was -67.6%. ... The worst calendar year for the broad bond market was 1994, when due to an unexpected [rise] in interest rates, the bond market returned -2.9%.”

So, the worst decline we've seen in bonds was chump change compared with the shellacking we've just experienced in stocks. And he adds that, historically, “a 3.5% bond is fairly valued.” That's about where ten-year Treasury notes are trading now.

Of course, it's often hard to identify a bubble before it bursts. But the herd mentality of buying bonds, the certainty among so many investors that they were safe (remember “home prices have never fallen” or “the Internet will change everything”?), and the sheer volume of the money make me think it was indeed a bubble, albeit one of the quieter ones we've seen.

Here's an astonishing stat for you: According to growth-fund manager Jim Oberweis, “the roughly $650 billion total [in bond inflows in 2009 and 2010] matched the equity fund net inflow during the Internet bubble period of 1998 through 2000.” So, one buying spree was a mirror image of the other, only a decade later.

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A Shift to Shorter Maturities

I'm certainly not expecting anywhere near the sell-off we've seen in stocks or housing, but I also wouldn't be surprised to see losses beyond the 9% decline bonds experienced in their worst 12 months.

Now I don't think investors should panic and dump their bond funds with the same alacrity they bought them. But I do think people should gradually shift their bond holdings to shorter maturities, which are less vulnerable to sudden price corrections.

And here's the good news: Kinniry said 95% of the cash flows into Vanguard bond funds went into short- and intermediate-term funds with maturities of five to seven years and less.

“We don't see very much at all in the long-term space,” he added. That, of course, is where the biggest losses can occur.

For instance, the Vanguard Long-Term Bond Index Fund (VBLLX) has fallen 9.6% from its August 31, 2010, peak. The equivalent intermediate-term bond fund has slid 4.3% from its recent high, while the short-term bond index fund is off only 1.2%.

That's why Richard Band recommends that people put most of their fixed-income assets into shorter maturities. He's particularly fond of fixed-interest certificates of deposit.

He also likes Weitz Short-Intermediate Income Fund (WEFIX), rated five stars by Morningstar, and run by Thomas Carney since 1996. During that time, says Band, he's “not had a loss.”

Full disclosure: Over the past couple of months, I've shifted much of my fixed-income money into short-term funds such as Vanguard Short-Term Bond Index Fund (VBISX).

By the way, Kinniry says Vanguard is projecting a 3%-4% total annual return for fixed income over the next ten years, vs. a healthy 9% in stocks.

“The No. 1 theme coming out of Vanguard is that we are optimistic, even bullishly, on the equity risk premium—the real return of equities vs. other assets,” he told me.
“The irony is, you should have had more bonds in 1998-1999. Now you probably need more equity.”

Personally, I don't expect many investors to follow his advice; they're still fighting the last two or three wars. But if you're worried that you have too much in bonds and can't bring yourself to take the plunge into stocks, I'd do what Band recommends: “When a rebound occurs, you should take some money off the table and rebalance” into shorter maturities.

“You've got to be able to sleep at night as well as eat during the day,” he said.

As long as you don't expect a free lunch.

Howard R. Gold is editor at large for MoneyShow.com and a columnist for MarketWatch.