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Weekend Investor
June 4, 2010, 6:38 p.m. EDT · Recommend (3) · Post:
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By Sam Mamudi, MarketWatch
NEW YORK (MarketWatch) -- 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.
A weak jobs report and fresh worries about the euro-zone's economy sparks selling in stocks, and solid gains in Treasurys and the U.S. dollar. Dow Jones Newswires' Paul Vigna joins the News Hub to discuss.
Yet unlike the technology- and credit-fueled bubbles which 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's 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've 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 are forced to 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. "Even Treasurys lost some of their principal during the first half of 1987."
But investors seem oblivious to the danger, in part perhaps because bond funds have not suffered such large losses in recent years.
From 1985 through 2009, bond fund returns, on average, dipped into negative territory just three times, with losses of 4.7% in 1994, 1.2% in 1999 and a 7.8% decline in 2008, according to investment researcher Morningstar Inc.
U.S. stock funds, by contrast, had six losing years, including tumbles of 12% in 2001, 23% in 2002 and 39% in 2008.
"People are conditioned to push the 'fixed-income' button [in times of trouble] because for nearly 30 years you didn't have to do anything to make money," said Bill Eigen, manager of J.P. Morgan Strategic Income Opportunities Fund /quotes/comstock/10r!jsoax (JSOAX 11.56, -0.01, -0.09%) , a bond fund with a flexible, go-anywhere approach.
Those smaller losses were enticing for investors reeling from 2008's heavy shelling. In 2009, bond funds saw a record $375 billion of new money come in, ending the year with $2.2 trillion in assets, according to the Investment Company Institute. By contrast, domestic stock funds saw $40 billion go out the door, ending the year with $3.7 trillion in assets.
Many investors may be surprised to hear that bond funds could be so vulnerable, in part because if one holds a bond to maturity the full principal is returned.
Not so with bond funds, which typically don't hold bonds to maturity. A long-term bond fund, for example, needs to keep its average holding maturity several years out, in part to keep yields up, so it cycles through bonds. Fund flows also play a part -- managers often need to buy and sell securities depending on the cash going in and out of the fund.
Interest-rate hikes may be many months away, but at that point bond-fund managers could have trouble as demand for lower-yielding securities becomes scarce and prices fall.
NBA Commissioner David Stern must be one happy guy these days, writes Jon Friedman.
3:00 p.m. June 4, 2010 | Comments: 4
- JohnChisum | 5:47 p.m. June 4, 2010
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