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Spooked by stocks and unfazed by the recent downgrade of U.S. debt, investors have turned to Treasurys as a safe haven. But are their moves inflating the risks in the broader bond market?
The latest Treasury rally has done little to quiet year-long concerns that bonds are in a bubble. Last week, investors flocked to government bonds, pushing yields on the 10-year Treasury below 2% for the first time in at least 50 years. That's also down from the 2.6% yield pre-downgrade, and below the 2.8% threshold first hit last October, when many took the view that the bond market was headed for a pop. Now bond bears say the latest rally is setting up the bond market for an even bigger crash once interest rates start to rise again. "You could potentially get whipsawed," says Elaine Stokes, co-manager of the $21 billion Loomis Sayles Bond fund (LSBDX).
To some, this may sound one more false alarm. The warnings -- whether from Bill Gross, manager of the $245 billion Pimco Total Return fund (PTTAX), or Sheila Bair, the government's top bank regulator -- have remained the same for months, and the bond market still hasn't collapsed. The Federal Reserve's recent announcement that it plans to keep rates low for another two years seems to signal another reprieve for bond investors; the Treasury rally has tempered this week as many bond investors await Fed chairman Ben Bernanke's speech this Friday in Jackson Hole, Wyo. "It certainly seems difficult at this juncture to make a case for rapidly rising rates," says Jeff Tjornehoj, a senior analyst for fund-tracker Lipper.
But even if rates stay low, counter the bond bears, the bubble is getting bigger -- and more dangerous. "The fundamental problems are still there," says James Sarni, managing principal at Payden & Rygel. "These rate levels aren't sustainable." Most bonds are priced relative to Treasurys, so if the rates on Treasurys are too low, then so are the rates on everything else. If and when Treasury yields start moving upward, the losses will have a ripple effect, says Stokes.
For bond investors, the damage could come in two waves: in the near term if rates rise to reflect positive economic growth, and again in the longer term as interest rates climb again. If rates rise, bond holders could be forced to sell their bonds for less than what they paid (or at least less than what they are worth today) as investors prefer newer bonds with higher yields. Longer-dated bonds are the most vulnerable, because the longer an investor has to wait for his bond to mature, the greater the chance that an increase in rates could diminish the value of that bond.
Better, says Stokes, to hold high yield corporate bonds, which are riskier than investment grade bonds and Treasurys but offer attractive yields that could offset some of the losses from rising interest rates. The average junk bond currently yields 8%. Another alternative: Dividend-paying stocks, since the average dividend yield on S&P 500 stocks, at 2.2%, is slightly more than the yield on 10-year Treasurys, says Tjornehoj, adding that stocks have more room for bigger gains.
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