Tuesday, June 8, 2010

Is the Bond Market Forming a Bubble?

From the WSJ:

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 tech-stock and credit-fueled bubbles that 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 is 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 have 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 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.