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In the early 1930s, after the 1929 crash, Wall Street could not get nervous investors interested in stocks again. However, with interest rates dropped to extreme lows in the Great Depression, those who still had money were eager to invest in something that would provide more income than they could receive on savings accounts. As a result Wall Street had no trouble selling them bonds.

It was later said to have been a slower disaster than the stock market crash, but almost as devastating. Bonds decline in price when interest rates and yields rise. Over the next two decades interest rates began to rise from their extreme lows, and the price of bonds declined. Investors new to bonds discovered it was not a safe haven to be receiving 4% annual interest on bonds if the bonds were dropping 10% in price annually due to rising interest rates.

I bring that up because of reports this week that the major US banks are on a tear to raise huge amounts of low cost capital by issuing bonds while rates are at record lows, and while investor demand for higher returns is on the rise as an alternative to stocks. Some of the low cost capital being raised is being used to pay off the higher cost bonds and debt on their books. Moody’s estimates that US banks have already refinanced $200 billion of the $372 billion in debt that is coming due in 2010.

The Financial Times quotes an executive with one of the big banks as saying:

There’s a bit of a food fight among investors to get hold of paper from US banks.

(It’s not the same situation in Europe where banks need to raise capital but are struggling to issue new debt in the midst of the eurozone debt crisis).

The large US banks are not the only corporations having an easy time issuing new bonds, benefiting from the flight to safety. Investors have been piling into corporate and treasury bonds for quite some time, and it continues. The Investment Company Institute, which tracks money flows in retail mutual funds, estimates that individual investors pulled another $9 billion from US stock funds in the first three weeks of July, even as the stock market was rallying again, and poured $20 billion more into corporate and government bond funds.

Tom Lee, chief US equity strategist at JP Morgan Chase, speaking at the Reuters Investment Outlook meeting in New York on Wednesday said:

Retail investors buying bonds today, at a time when the supply of corporate bonds is shrinking . . . they’re chasing a bubble.

Assuming the issuer does not default on its bonds, an investor will not lose money on individual bonds if they are held to maturity, when the issuer returns the borrowed money to the investor. However, holding to maturity may be difficult, as bond investors discovered in the late 1930s and 1940s, once stocks begin producing 10% to 25% in some years, while the 20-year corporate bond will continue to pay only 4.5% or whatever annually to maturity (and meanwhile may be significantly underwater until maturity due to rising interest rates).

As Tom Lee of JP Morgan also said Wednesday:

Have Americans ever been satisfied with earning a steady but low rate of return? What we have in American history is rolling from bubble to bubble, whether it’s stocks, real estate, commodities, emerging markets, time shares . . . when one bubble bursts they are moved to the next one.

Lee implies that the bubble currently forming is in bonds.

But it should be okay as long as the Fed holds interest rates at record low levels near zero for “an extended period of time” as they say they will, and particularly if the stock market has another leg to go on the downside (keeping the appeal of safe havens alive). Investors probably need to be aware of the potential that it is a bond bubble, and be prepared to bail out early when rates and yields begin rising, or if the stock market bottoms and begins a new leg up. With so much money in bonds and bond funds, the exit doors will be crowded when the time comes.

Disclosure: No positions

Source: Are Investors Being Set Up for Another Fall?