With the stock market still in flux, bond funds are continuing to attract new money from investors seeking a safe haven, even as some critics warn they may be part of a bubble trap.
The two funds that have attracted the most investor dollars so far this year are bond funds – the PIMCO Total Return and the Templeton Bond, which have garnered more than $25 billion combined this year, according to Morningstar.
Investors poured $118 billion more bond funds than they took out during the first five months of the year, up from $106 billion during the same period in 2008, and $77 billion over the same stretch in 2007, according to Strategic Insight, an industry research firm. They’ve put more than $400 billion in since the beginning of 2009.
After the tech and real estate busts, market observers began wondering whether the next bubble could be in bonds. The recent influx of new money into bond funds has drawn added scrutiny to the debt security market.
“We think this little fear rally, over the possible double dip is going to prove to be a little overdone,” says Burt White, the chief investment officer of LPL Financial. “There was way too much fear given the scenario, and when that unwinds you’ll see bonds sell off, especially high quality.”
A bubble occurs when the price of an investment exceeds its underlying value, often because of panicked or irrational buying. When the bubble bursts, panicked selling can occur and prices can plummet, creating steep losses for those bought at the wrong time (or essentially paid too much).
Whether bond and bond fund prices have been pushed too high is a matter of debate, but the volume of buying has attracted several theories. Although many agree that the bond market is now a bubble or at least bubble-like, some differ on their forecast for the aftermath.
A bond bubble won’t suddenly pop, says Doug Roberts, chief investment strategist for Channel Capital Research. He says that the phenomenon can be drawn out for an extended period of time, even in an inflationary environment.
Others, like LPL Financial’s White, say bond holders are facing imminent problems.
Here are three indicators that market watchers are using to gauge if and when the so-called bond bubble will reach capacity.
A growing taste for risk
If investors were to reverse to the so-called fear trade, or their flight to traditionally safe investments, more money would flow into riskier areas like equities.
A movement back toward riskier plays would likely be made in “baby steps,” says White. It might begin with an increase in prices for high-yield and investment-grade credit, he says. Then, money would flow into commodities, followed by equities. Credit and commodities tend to move in a V-shape during a recovery, says White, so the upswing would be more pronounced. He expects the flow into equities to be more volatile and to occur only after the so-called bond bubble has burst.
A marked change in returns
A ruptured bond bubble would include a significant rise in yields and decline in prices. The 10-year Treasury’s yield has ranged from about 3.16% to 3.90% so far this year. It’s recently been closer to 3.3%, a technically significant point of resistance, White says. If the yield on the 10-year Treasury were to break above 3.30% and hold, “then we think we’re going to be moving north,” White says, adding that the next resistance level is 3.60%. A significant and lasting jump higher would probably be “disastrous for high-quality bond prices,” he says.
The inflation picture
When consumer prices rise, the fixed interest an investor earns from bonds is worth less. For instance, for the 1940s, the total return over the decade on long-term government bonds (with an approximate 20-year maturity) was 3.2%, but the compound annual rate of the consumer price index for the decade, as measured by the Bureau of Labor Statistics, was 5.4%. During the 1950s, the yield was -0.1%, and inflation stood at around 2.2%. Essentially, bonds weren’t returning enough to make up for the rate at which money was losing value, making them hard to sell. “When inflation starts exceeding what you are getting on long-term bonds, that’s when you get in trouble,” says Roberts.
Some market watchers warn that the amount of money injected into the economy through stimulus and recovery efforts combined with sustained low rates will spark inflation. Investors had been concerned about inflation over the past year, with China stockpiling commodities and the dollar on the decline. However, the crisis in Greece and p1ressure on the euro has led to a stronger dollar, alleviating some of those fears. Import prices and the consumer price index – the leading gauge of inflation – also suggest inflation has been subdued.
Throughout history, even with the injection of money into the economy, inflation has been more highly correlated to times of war and interruptions of supply, says Roberts. He adds that neither poses a significant price threat now.
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