Bonds in the 'danger zone'

By Colin Barr, senior writer

(Fortune) -- Even bond managers are questioning the wisdom of buying bonds now.

Government bond prices are sliding as an economic recovery takes hold and the feds struggle to fund a massive budget deficit. At the same time, the prices of corporate bonds are looking expensive after a ferocious year-long rally.

With forecasters projecting higher interest rates and the market anxiously awaiting the Federal Reserve's next baby step toward normal policy, some strategists are counseling investors to hold more cash -- and to brace for a wild spring.

"We're in the danger zone," said Bill Larkin, a portfolio manager at Cabot Money Management in Salem, Mass. "There's likely to be some sort of hit to the bond market."

Facing an onslaught of government bond issuance, investors are demanding higher yields on Treasury debt. The yield on the 10-year Treasury note hit 4% Monday for the first time since October 2008, the height of the financial crisis. The government is preparing to sell $167 billion worth of Treasury debt this week.

The rise in yields comes after a number of Treasury auctions in recent weeks drew tepid demand. An auction of 10-year notes this Wednesday "could be problematic," Larkin said. He recommends investors who want to add bond exposure stick to maturities of three years or less.

At the same time, the quick bounceback in the markets over the past year has sent the prices of corporate, municipal and mortgage bonds soaring. That brought yields way down, leaving some investment managers with an all too familiar feeling: that they aren't being compensated for the risk they're taking in buying certain bonds.

"It feels like we're starting to go too far, too fast," said Benji Bailey, co-manager of the MMA Intermediate Income fund.

A year ago, debt issued by some speculative-grade bond issuers such as department store Bon-Ton (BONT) and drug chain Rite-Aid (RAD, Fortune 500) was trading at less than 20 cents on the dollar. Yields rose as high as 83% for Bon-Ton's 10.25% senior notes due 2014.

By last month, the Bon-Ton bonds had recovered to trade above 93 cents on the dollar, bringing the yield back down to just over 12%.

A similar trend has played out among high-grade corporate and municipal issuers, as well as in mortgage bonds, whose prices have surged, helped in large part big purchases by the Federal Reserve. The Fed's spending spree has totaled $1.4 trillion.

While the rising prices reflect the government's apparent success in averting a rerun of the Great Depression, they appear optimistic given the high level of unemployment, the slow pace of recovery and the mountains of debt piled atop the economy.

"It's starting to feel like 2006-2007 again, with everyone chasing yield," said Bailey.

The yield chasers will be keeping an eye on the Federal Reserve, which has been holding short-term interest rates near zero in a bid to boost capital at the banks and restart economic activity. Fed chief Ben Bernanke said Feb. 10 that the central bank would soon raise its discount rate, the rate it charges banks borrowing in an emergency.

The Fed then raised that rate Feb. 18, and investors are now wondering whether another hike is on the way. The Fed's Board of Governors, which controls the discount rate, met Monday.

When the next boost in the discount rate comes, it would be but the first step in a long march away from the free money that has defined the past year. The Fed remains months from even discussing, let alone raising, the rate everyone watches, the fed funds overnight bank lending rate.

"All we're talking about is a move to accommodative from crazy," said Larkin. To top of page

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