Dot-coms, credit - bonds? Analysts say another bubble is possible

NEW YORK - They say that bad things come in threes, and in the past decade investors have seen two market bubbles burst. Now some money-managers believe a third downturn is in the making - in bonds.

And just as the previous losses were made worse by investors rushing headlong into assets that showed signs of overheating, bond prices are being inflated by investors pouring cash in at record rates.

Yet unlike the technology- and credit-fueled bubbles which resulted from eager buyers chasing returns, this latest bubble is forming in part because frightened investors want to minimize risk and avoid further losses.

After the fall of technology stocks in 2000 and the financial crisis of 2008, many investors shunned stocks and headed for the perceived safety of fixed income. But that stampede into bonds, coupled with changes in the economy, threatens investors with losses in their longer-term bond funds.

That's because interest rates will likely rise in coming years from a base of almost zero today. Higher rates slam bond values. But investors mostly only know what they've seen in the past 25 years, which for the most part has been a period of steadily declining interest rates and rising bond prices.

Moreover, the flood of cash cascading into bond funds forces managers to buy securities in a low-rate environment. When rates move higher and the value of their bond holdings slides, many fund investors are likely to head for the exits - further baking in losses as managers are forced to sell to meet redemptions.

"It's fallacious reasoning that you can't lose money in bonds," said James Swanson, chief investment strategist at MFS Investment Management. "Even Treasurys lost some of their principal during the first half of 1987."

But investors seem oblivious to the danger, in part perhaps because bond funds have not suffered such large losses in recent years.

From 1985 through 2009, bond fund returns, on average, dipped into negative territory just three times, with losses of 4.7 percent in 1994, 1.2 percent in 1999 and a 7.8 percent decline in 2008, according to investment researcher Morningstar Inc.

U.S. stock funds, by contrast, had six losing years, including tumbles of 12 percent in 2001, 23 percent in 2002 and 39 percent in 2008.

"People are conditioned to push the 'fixed-income' button (in times of trouble) because for nearly 30 years you didn't have to do anything to make money," said Bill Eigen, manager of JPMorgan Strategic Income Opportunities Fund, a bond fund with a flexible, go-anywhere approach.

Those smaller losses were enticing for investors reeling from 2008's heavy shelling. In 2009, bond funds saw a record $375 billion of new money come in, ending the year with $2.2 trillion in assets, according to the Investment Company Institute. By contrast, domestic stock funds saw $40 billion go out the door, ending the year with $3.7 trillion in assets.

Many investors may be surprised to hear that bond funds could be so vulnerable, in part because if one holds a bond to maturity the full principal is returned.

Not so with bond funds, which typically don't hold bonds to maturity. A long-term bond fund, for example, needs to keep its average holding maturity several years out, in part to keep yields up, so it cycles through bonds. Fund flows also play a part - managers often need to buy and sell securities depending on the cash going in and out of the fund.

Interest-rate increases may be many months away, but at that point bond-fund managers could have trouble as demand for lower-yielding securities becomes scarce and prices fall.

Compounding the problem is that many investors don't remember when bond funds did lose money for a prolonged period.

"A multiyear move of rising interest rates is an environment that most people haven't seen before," said Tom Atteberry, co-manager of FPA New Income Fund.

The last time rates rose over several years was three decades ago. From June 1977, when the rate on 10-year Treasurys was 7.33 percent, rates climbed steadily, peaking at 15.32 percent in September 1981. And as rates rose, bond funds suffered.

Long-term bond funds were on average down 0.7 percent in 1977, lost 1.2 percent in both 1978 and 1979 and 3.9 percent in 1980, according to Morningstar. Each year's loss was relatively small, but the losing streak lasted for four years.

It was a similar story in 1994, when 10-year Treasury yields jumped to 7.81 percent from 5.77 percent.

It's not just about rising rates. If - or when - inflation pressures build, even bond funds posting modest gains will end up losing money in real terms.

One reason people have flocked to bond funds is fear. Even the cumulative bond-fund losses of the late 1970s don't compare with what investors have suffered at the hands of stock funds in recent years, with three double-digit losses in the past decade alone. Investors may have decided that potential small losses in bond funds are preferable to a major hit from stocks.

JPMorgan's Eigen, for one, is keeping his fund on the safe side. The portfolio's average duration - its sensitivity to interest-rate fluctuations - is about seven months, and half of the $9 billion fund is in cash. Eigen said investors underestimate the risks in all medium- to long-term bond classes, with the possible exception of high-yield bonds.

High-yield bond returns will remain attractive enough - nowadays they yield about 7 percent to 8 percent more than Treasurys - that their prices should hold up, he said. "That's not the case with any other (bond) asset class."

Investors determined to avoid stocks in a volatile market should invest in shorter-term bond funds - perhaps with five-year durations - that can at least keep pace with inflation, and wait out uncertainty in the economy and the markets, Atteberry said.

Once stability returns, stocks could shine in a higher-rate environment.

Susan Fulton, president of Bethesda, Md.-based wealth manager FBB Capital Partners, said she tells clients they need a minimum of 30 percent invested in stocks to beat long-term inflation risk.

A portfolio divided equally between stocks and bonds is the "sweet spot" in terms of delivering returns proportionate to risk, Fulton added. Most of the bonds she holds, she said, mature in less than seven years, and she uses either exchange-traded funds or individual bonds rather than mutual funds.

"People heading into long-term bonds think they're going there for safety, but they're making a very aggressive bet," said Fulton. "You need to diversify."

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