Don't Get Bullied Out of Bonds

by: Jon D. Markman
Bonds have provided a welcome safe-haven for investors seeking shelter from the financial maelstrom of the past two years, offering steady returns while stocks bounce up and down. Now some analysts are afraid that once the selling of bonds begins it will be indiscriminate, and there will be a bloodbath. But that fear totally ignores the new investment reality in which we're living.

The fact is, stocks won't be crawling out of the gutter anytime soon, and until they do, investors will continue to look elsewhere for a store of value. They have already decided they can find it in two places: U.S. bonds and gold.

American equity mutual funds this year have seen net outflows of $7 billion, and bond funds have had inflows of $191 billion, The Economist reported last week. In fact, bond funds attracted $559 billion in the 30 months through June, according to the Investment Company Institute (ICI). In that same period, investors withdrew $209.4 billion from U.S. stock funds and $24.4 billion from funds that buy foreign stocks.

That certainly appears to be bubble territory, but it still doesn't mean that bonds are destined to come completely unraveled. The only thing that could truly dislodge bonds would be if stocks made a decisive climb upwards. Such a surge would have to be persistent enough to make investors feel like they're about to miss a new bull market. And I'd say there's only about a 30% likelihood that such a climb will occur. The far more likely case would be a continuation of the recent muddle-through, with major indexes struggling to build momentum.

So I disagree with the assumption that there's something wrong with owning bonds. Despite their risks, bonds have a role in most investors' portfolios to varying degrees.

Here's a thought: During the late 1970s and early 1980s, people around the world grew to trust central banks run by Paul Volcker in the United States, and Karl Otto Pohl in Germany. They tamed inflation and preserved the value of their national currencies.

But now after the failures of the 2008 credit crisis, investors have no heroes among monetary authorities. Responsible bankers like Volcker and Pohl are scarce, and this makes investors queasy. Moreover, investors are uncomfortable with the euro, and shell-shocked over the size of the devaluations implicit in monetary stimulus.

Meanwhile, developed-world investors are growing older, and have long-term obligations to their families. So there is high demand for reliable investments like bonds.

I doubt that even a surge in U.S. and European economic growth, should it occur, would alter this decision. And when stocks do begin to levitate and attract more funds, there is plenty of money in cash that can be moved into them, while bonds retain their own role in portfolios.
Bond Boom

Additionally, there's a mistaken belief that if stocks go up in value, bonds have to go down. There is no fixed rule or precedent to substantiate that belief. Bonds have been in a thirty-year bull market while stocks have risen and fallen. Bonds have mostly gone up when stocks have gone up, and then they've also gone up when stocks have fallen.

To be sure, U.S. Treasuries are relatively high now, but my expectation is that they will only come down about 10% to their long-term uptrend. Credit will decline in value when interest rates rise, but I still expect the U.S. Federal Reserve to stick with its zero interest rate policy through 2011.

And remember, there is a great wide world of debt to own besides Treasuries, including U.S. corporate bonds, emerging market sovereign and corporate bonds, closed-end funds that own distressed debt, and more. I don't think we have seen the end of investors' need or desire to own stable, income-paying securities.

Disclosure: None

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