Danger Ahead in the Bond Market

Jun.27.10 | About: iShares iBoxx (LQD)

We have seen two bubbles burst in the last decade: the technology bubble and the credit bubble, and now, we could be staring down a third bubble…in bonds.

And this bubble is like the first two in that it is being inflated by investors pouring money into bonds at a fever pitch. But, unlike the purely greed-driven tech and credit bubbles, the bond market bubble is being driven by fear as well. And fear is a powerful force.

How powerful? As of April, bond funds experienced inflows of $118.7 billion for the year (a 45% increase over a year ago), according to the Investment Company Institute. And that’s just the first four months. Inflows of $380 billion are expected for the year; that’s more than what was poured into domestic stock funds in the past decade, according to Money Magazine.

Fear (and a little greed) is bringing investors into bonds in record droves. But investors have been lulled into a false sense of security in believing that bonds (and bond funds) are the safest bet. In reality, there are serious threats to bond values on the horizon.

First of all, when rates rise, bond prices, especially long-term, will fall (bond yields and prices have an inverse relationship). And when will that happen? It will be a while yet: when the Federal Reserve’s FOMC meeting takes place this week, chances are the committee will maintain the “extended period” for low rates. And what’s more, the Wall Street Journal reported last week that the Fed will contemplate moves in case the recovery loses traction, which could push a rate increase further out. Still, rates have only direction they can move from near zero… and when they rise, it will be a day of reckoning for the bond market.

Another problem: inflation. At some point consumer prices will rise (CPI declined .1% in May, but on a yearly basis rose 2%). And the reality is that the government may have little choice but to continue to inflate the deficit away. It might be a while before we see any serious inflation, but when we do it will eat into the dollar’s purchasing power (and that means it will eat into the power of bond investors principal).

Another problem is the behavior of bonds versus bond funds (bond funds respond differently to interest rate fluctuations). An investor holding individual bonds is at least assured of return of their principal. But that’s not necessarily the case with bond funds, because they regularly buy and sell securities based on flows in and out of the fund. And when investors flee funds, managers are forced to sell bonds to meet those redemptions. So, when interest rates eventually rise, bond funds (especially long-term) stand to decline substantially.

As Investment News put it, the prevailing sentiment among investors seeking safety is that “return of principal is more important than return on principal”. But the bottom line is that we are likely facing a bond market bubble, and that perceived sense of security will quickly disappear.

As for investing, my only recommendation for the bond market is short to medium-term, investment grade corporate debt. I would avoid any long-term bonds, as well as Treasuries.

Take a look at iShares iBoxx $ Invest Grade Corp Bond (NYSEARCA:LQD): this ETF will provide exposure to medium-term investment grade corporate debt.

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Source: Yahoo Finance

Disclosure: Rezny Wealth Management does not currently hold a position in LQD; positions can change at any time.