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As many investors have shunned stocks and turned to long-term fixed income to park their investment dollars, the safety of bonds, and the ETFs that hold them, may be in jeopardy.

The first reason the bond market might be in trouble is because prices are being inflated. With concerns in the overall health of the global economy, the fear of a double-dip recession and unemployment levels remaining at stubbornly high levels, numerous investors are shunning risk and turning to bonds. In fact, over the last year, net inflows into fixed income investment tools have outpaced net inflow into equities by nearly tenfold. The Investment Company Institute reports that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows. This trend in turn has pushed long-term bond prices up and yields down. In fact, on an inflation-adjusted basis, there is a negative yield for most short-term bonds.

A second factor that could be detrimental to bonds is the likely rise in interest rates in coming years. Granted, economic slack, low inflation levels and stable inflation expectations will likely enable the Federal Reserve to maintain its target rate at record low levels through 2010 and even into 2011, however, the Fed will eventually have to tighten rates to reduce its balance sheet and normalize its engagement with financial markets. This will make bond trading less attractive and will likely hinder bond values.

Lastly, inflation could hinder the bond markets. With the U.S. federal deficit surpassing the $1 trillion mark, the Federal Reserve will likely have no other choice than to print dollars and increase money supply. If, and when, this happens, increases in the consumer price index will eat away at the yields and real returns on bonds.

Some bond ETFs that are being influenced by this trend include:

  • iShares Barclays 1-3 Year Treasury Bond (SHY) which has a yield of 1.23% and closed at $84.29 on Monday.
  • iShares Barclays Short Treasury Bond (SHV), which has a yield of 0.14% and closed at $110.21 on Monday.
  • iShares S&P/Citi 1-3 Yr Intl Treasury Bd (ISHG), which has a yield of 1.04% and closed at $99.61 on Monday.

To further mitigate the risks involved in the aforementioned bond ETFs, implementing an exit strategy to help stop the bleeding if the bubble were to burst is of importance.

Disclosure: No positions

Source: Three Reasons Bond ETFs May Indeed Be in Bubble Territory