Bonds: Avoid the next great bubble

(Money Magazine) -- As manias go, this one is different. Your neighbors aren't coming up to you at cocktail parties bragging about making a killing in bonds. No one is flipping fixed income for quick profit. And no talk-radio guru is shouting that bonds will be the only investment left standing after the next financial Armageddon.

Don't let the lack of fanfare fool you. A projected $380 billion will pour into bond funds this year, more than went into domestic stock funds in the past decade. That's on top of a record $376 billion last year.

"The bond market is a bubble," says Robert Froehlich, senior managing director of the Hartford Financial Services Group. "And it's getting ready to burst." One major reason: Despite the recent rally in treasury bond prices and slide in yields -- due to fears over the European debt crisis -- the long-term direction for interest rates is headed higher.

Like all financial manias, this one is being fueled by a combination of fear and greed.

James Stack, a market historian and president of InvesTech Research, notes that many baby boomers who have stampeded into bond funds did so in reaction to their stock losses since the financial crisis began in 2008.

"It's post-traumatic shock," he says. Even with the rebound in equities since March 2009, "investors fear putting money into the stock market because they have a newfound respect for the risk equities pose."

Over the past decade, holding bonds was considerably safer than holding stocks. After the tech bubble burst in 2000 and equities lost almost half their value over the next three years, corporate bonds surged nearly 50%. And when the global financial crisis erupted two years ago, U.S. Treasury bonds were just about the only investment to retain value. The flight to safety in recent weeks, driven by concerns over Europe's mounting budget problems, has moved investors back into treasuries for the time being yet again.

On top of that, few investors know what it's like to live through a true bear market in bonds. Fueled by falling interest rates (long-term rates were as high as 15% in the early '80s), the current bull market has lasted for 30 years.

The resulting sense of safety -- the belief that bonds don't go bad -- is contributing to this feeding frenzy in fixed-income funds and ETFs. And all that money flowing in has made bonds very expensive.

You can see how frothy Treasuries are by calculating a P/E of sorts for bonds; just divide the bond's price by its current yield, not by earnings. At a price of around $100 and a yield of 3.3% -- up from 2% in december 2008 -- 10-year Treasurys have a P/E of 30. That's around twice their historical level.

It's true that bonds are less volatile than stocks. But in fact they lose money just as often as equities do. "I don't think the public understands they can lose money in bond funds," says James Swanson, chief investment strategist at MFS, an asset-management firm in Boston.

So that's the fear part. The greed part comes from an entirely different group of people: safety-loving folks who normally park their money in cash, such as bank savings accounts, CDs, or money-market funds. Fed up with the meager interest rates those accounts are paying these days -- the average taxable money-market fund yields 0.03% -- they're venturing into short-term bond funds to eke out a bit more yield.

One part of the bubble is already leaking air: long-term government bond funds. Because they invest in supersafe U.S. Treasuries and other forms of government-backed debt, they were a popular place to hide during the mortgage meltdown.

But when the economy began improving and rates on 10-year Treasurys began rising (from about 2% at the end of 2008 to as high as 4% in April before slipping to 3.3% today), these funds started suffering. In fact, the Vanguard long-term Treasury bond fund fell 12% in 2009 and, despite the recent run up in Treasury securities, is still down 5% since the end of 2008.

Experts say that's just the beginning. Here are the major factors that could harm bonds further.

Rising interest rates. "Rising rates are the biggest concern out there for bonds," says Mario De Rose, fixed-income strategist for the brokerage Edward Jones in St. Louis. That's because they make older, lower-yielding bonds that you or your funds own look less attractive compared with newer securities.

Let's say you bought a 10-year Treasury at the current rate of 3.3%. If rates rose to, say, 4.3%, the price of the bond would fall by nearly 8%, according to T. Rowe Price. So even though you'd be earning interest income, your actual total return would be 4%.

Alas, even if rates continue to tick down for a bit, the long-term trend is up. Economists at Standard & Poor's think the yield on 10-year Treasuries will jump to 5.3% by 2012; Froehlich of Hartford predicts it could hit 6.5% much sooner than that.

In a rising-rate environment, individual bonds have an edge over bond funds. You can simply hold individual bonds to maturity, at which point the issuer promises to give you back your original investment in full. That's impossible with funds, which hold lots of issues and are constantly buying and selling. Fixed-income funds can still make sense for a lot of reasons. But "they are the worst investment when it comes to rising rates," says InvesTech's Stack.

The return of inflation. Even individual bonds are no match for the power of an overheated consumer price index. Bonds tend to do well in periods of falling, not rising, inflation. From 1980 to the end of 2009 -- when the annual growth in the consumer price index fell from nearly 14% to virtually nil -- bonds delivered higher-than-average returns of nearly 10% a year, according to Ibbotson Associates.

With the federal deficit now projected to exceed $1 trillion this year and next, the Federal Reserve has little choice but to effectively crank up the amount of money in circulation. So there's a real chance that inflation -- nonexistent now -- could start running as hot as 5% in the next few years. If that happens, the real return on any bond yielding below 5% would be wiped out entirely.

Lingering doubts about the economic recovery. Most experts believe that the global economy is on the mend. But ongoing struggles in the housing market, a rise in mortgage defaults among owners of commercial properties, or a spread of the debt crisis in Europe are still possible, says Jeremy Grantham, chief investment officer of GMO, an asset-management firm in Boston. Any of those could damage the financial health of the countries or companies that issue bonds.

If investors become concerned that certain bond issuers are less creditworthy, their debt will become less desirable, weighing down bond prices. For example, thanks to growing worries about the debt crisis in Greece, Spain, and Portugal, many funds that specialize in European bonds are down so far this year. American Century International Bond, with around two-thirds of its assets in debt issued from European countries, has fallen more than 7%.

Panic selling. In today's low-rate environment, some bond fund managers -- even those who run short-term funds -- are taking extra risks "to reach for extra yield," says Russel Kinnel, director of fund research for Morningstar.

For instance, they might invest in bonds issued by entities of questionable financial health. The results aren't always pretty. In 2008 several short and ultrashort funds posted staggering losses (35% in the case of Schwab YieldPlus) as the credit crisis crushed bonds that they held.

Remember all those Johnny-come-latelies who recently moved from money-market funds to bond funds? At the first sign of trouble, many of them are likely to flee back to cash, warns Marilyn Cohen, president of Envision Capital Management, an advisory firm in Los Angeles that manages bonds for individual investors.

If the selling is severe enough, fund managers could be forced to dump bonds to meet redemptions, making other bond investors' losses worse. That risk is especially high with bonds that trade infrequently. Holders might accept fire-sale prices to get out in a hurry -- that rush to sell exacerbated losses suffered in the credit crisis.

Does this mean you should junk your bond holdings? No. If used properly, bonds will help you diversify your portfolio and generate much-needed income. Instead, try these strategies to protect yourself from the worst effects of a bond meltdown.

Shorten your durations. "Duration" measures how sensitive an investment is to interest rate changes. If a bond or bond fund has a duration of five years, for example, its price is likely to rise around 5% if interest rates fall by one percentage point. Conversely, if rates rise by one point, the price will fall by around 5%. The longer the duration, the higher the risk of losses. In this rising-rate environment, MFS's Swanson advises investors to stick with durations of around four years or less.

If you own a long-term government bond fund, consider replacing it with a shorter-term one with a duration in Swanson's target zone. Also check out the duration of the intermediate- and short-term funds you already own. You can do so by going to Morningstar.com, typing in your fund ticker, and clicking the Portfolio tab.

There can be significant variation within categories. While the average duration of a typical intermediate-term government bond fund, for example, is about four years, that of Managers Intermediate Duration Government (MGIDX) is only 2.9 years.

Buy TIPS rather than regular Treasuries. Treasury Inflation-Protected Securities yield significantly less than regular Treasury bonds right now (around 1.3% for 10-year TIPS vs. 3.3% for regular Treasuries of similar maturities). But TIPS have one big advantage: The interest they pay is adjusted to reflect changes in the consumer price index.

Jason Brady, a managing director at Thornburg Investment Management in Santa Fe, points out another plus. When interest rates rise (which is typical during periods of higher inflation), demand for TIPS is likely to be stronger than for plain-vanilla Treasuries. That means TIPS' prices are unlikely to fall as far.

These days it makes sense to buy individual TIPS rather than mutual funds that hold them. For one thing, it's easy to buy the bonds directly from Uncle Sam at Treasurydirect.gov. You'll pay no commissions or other fees. And the minimum investment is just a hundred bucks. As for maturity, choose one of no more than 10 years. And make sure you won't need the principal back before the end date.

Shift some short-term money to floating-rate bank funds. These funds invest in short-term, adjustable-rate bank loans made to corporations. Because such loans often reset every one to six months, "you get more income as rates rise," says Brady. The average bank loan fund has returned around 3% so far this year, compared with 2% for the average short-term bond fund.

But banks make many of these floating-rate loans to companies with less-than-pristine balance sheets. Stick with funds that focus on more creditworthy companies, such as those whose debt is rated BB -- just a couple of notches below "high quality" -- or above. One example: Pioneer Floating Rate (FLARX). Check a fund's credit quality at Morningstar.com.

Raise the credit quality of your munis. Battered municipal budgets will improve eventually, assuming the economy continues to heal. But historically, states and cities are among the last financial entities to emerge from a downturn. "I am not worried about credit risk among corporations, but I am worried about it in the muni space," says Envision Capital's Cohen.

To lower that risk, go with funds that invest mostly in municipal bonds rated AA or higher, like Fidelity Intermediate Municipal Income (FLTMX).

Lower the credit quality of your corporates. Move some of your corporate bond stash to high yielders. That's right: junk bonds.

This strategy isn't as crazy as it sounds. Junk bonds aren't as sensitive to rising rates as investment-grade bonds are, in part because their higher payouts provide a cushion if bond prices start to fall. In the past three periods when rates rose -- 2005, 1999, and 1994 -- high-yield bonds outperformed Treasuries by an average of 10 percentage points, according to an analysis by T. Rowe Price.

Moreover, if rates are rising because the economy is improving, demand for these bonds will climb. "A small positive change in the economy could have big changes in the fundamentals of these types of companies and their ability to pay back their debt," says Carl Kaufman, manager of the Osterweis Strategic Income fund.

That said, if investors fear the economy is headed into another storm -- as was the case in recent weeks -- high-yield funds could sink along with the broad stock market. In fact, the average high-yield fund has fallen nearly 4% over the past month (though it's still up more than 25% over the past year).

Given that the global economy hasn't fully recovered, stick with relatively conservative high-yield funds that avoid companies with the ugliest balance sheets. One such fund is Vanguard High-Yield Corporate (VWEHX). The typical bonds in this fund are issued by companies with ratings of BB or higher.

Don't give up on foreign bonds. The recent Greek tragedy may have you wondering if it's time to repatriate your entire fixed-income portfolio. Resist the urge.

As we've mentioned, Greece's debt problems have hurt the price of government bonds from Portugal and Spain. (Long-term Greek bonds now yield more than 8%, a reflection of how risky they are.) But those from many other European countries, including Germany and Britain -- whose government bonds yield almost exactly what U.S. Treasuries do -- have held up decently.

You should be looking beyond just Europe anyway. It's smart to diversify your fixed-income stake around the world because interest rates in different regions are expected to climb at different rates.

Another plus: If rates rise because of hotter inflation as expected, bonds from commodity-driven countries such as Australia, Brazil, and Canada will do well, says Thornburg's Brady. At the very least, they're highly unlikely to spoil your portfolio.