Flight to quality is boon for bonds

NEW YORK (CNNMoney.com) -- Investors have flocked to the relative safety of the bond market lately as the fallout from the subprime loan debacle has caused fears of a recession.

Treasury prices have surged in recent weeks, pushing the yield on the benchmark U.S. 10-year Treasury note below 4 percent. (Bond prices and yields move in opposite directions.)

Bond prices eased slightly Tuesday after a rally in the previous session pushed the yield down to 3.85 percent, the lowest level in two and a-half years.

Meanwhile, the stock market has been battered. The decline in the major indexes Monday left them down 10 percent from the highs they reached in October, putting the market into the technical definition of a correction. Stocks did bounce back Tuesday, however.

Still, some market experts say investors are putting their money in bonds instead to escape the volatility in stocks.

"When things get scary in the market, bonds are seen as a safe investment," says Stephen Cooke, director of credit research at SMH Capital Advisors.

Treasurys are backed by the federal government, so investors know that their funds will be protected in the bond market since, as Cooke puts it, "the government is not going to default."

Now, with the possibility of a recession looming large, is a particularly scary time to be in the stock market.

"Everyone has a good feeling that the economy is heading into a slowdown, possibly a recession," says Steve Van Order, chief fixed income strategist at Calvert Funds.

Some investors think the current economic conditions are bleak enough to cause the Federal Reserve to cut interest rates again when it meets on December 11.

The Fed often cuts rates in times of economic weakness with the hope that rate cuts will stimulate growth. That's because rate cuts make it less expensive for businesses and consumers to borrow money.

The Fed lowered interest rates by a quarter of a point to 4.5 percent in October, but implied at the time that another cut might not be imminent.

Nevertheless, Cooke thinks the Fed will cut the federal funds rate by another quarter of a point in December, adding that, "it would unsettle the markets if they don't."

Jonathan Smith, chief investment officer of fixed income at Haverford Trust, says the bond market is sending a signal that the Fed's reluctance to cut rates, "is the wrong thing to do."

The yield on the 10-year is lower than the federal funds rate, a possible sign from bond investors that the Fed should lower rates even further in order to stave off a recession.

If economic conditions continue to worsen into next year, Van Order thinks the Fed could cut rates to as low as 3.5 percent.

So what will this mean for bonds? Van Order said that if rate cuts help resolve the problems caused by the subprime meltdown, economic conditions could improve later next year and investors might have more incentive to move back into stocks.

That would probably be bad for bonds as investors would sell off Treasurys and other fixed-income securities. That would lead to higher bond yields.

"The wild card will be the economy," he said.