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Jan. 20, 2012, 5:15 p.m. EST
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By Wallace Witkowski, MarketWatch
SAN FRANCISCO (MarketWatch) "” Bond buyers enjoyed another banner year in 2011, with total returns in all classes outperforming the broad U.S. stock market, and investors continuing to pile into bonds and shun stocks.
The strong pace set by the market since Jan. 3 hasn't persuaded skeptics that the rally has legs, Brendan Conway reports on Markets Hub. (Photo: Reuters)
The celebrity status for bonds troubles some investors and investment strategists. They sense that this great bond bull market will slow in 2012. Not that sticking with bonds at this juncture is a recipe for disaster, but with more of their nest-egg tied to fixed-income securities, investors need to ask some hard questions.
Start with the worst case "” what would an investor do in the admittedly unlikely event where a "perfect storm" collapses the bond market and spikes yields. (Bond prices and yields move inversely.)
For that to happen, several developments would need to converge, said Mark Luschini, chief investment strategist at Janney Montgomery Scott.
In this scenario, bond investors would be surprised as U.S. job growth accelerated dramatically, the sovereign debt crisis in Europe found a clear solution, China's economy demonstrated a so-called soft landing and a pickup in growth, and the Fed ended Operation Twist and implemented a third-round of quantitative easing, Luschini noted.
"It would have to be a confluence of those things that could put pressure on bond prices," Luschini said. "One ... alone would not be enough of a shock."
A more realistic possibility is that stronger than expected economic growth spurs U.S. interest rates, raising yields and making existing bonds less attractive.
Harvey Rowen, chief investment officer at Starmont Asset Management, said that higher interest rates is one of his chief concerns about his bond positions. As an example, Rowen said a bond portfolio with an average maturity of 10 years could shed up to 20% in value if interest rates rise by two percentage points.
Rowen said the yield on the 10-year Treasury has tumbled from around 4% to about 2% in less than two years because investors thought "the world was coming to an end." But, he noted, "at some point people are going to say the world's not coming to an end" and Treasurys' safe-haven qualities won't be in such high demand. Read more: Why stocks will beat bonds over the next 20 years.
That said, as the fixed-income analysts at DWS Investments put it in a recent research report: "One could argue that U.S. Treasury yields probably won't go much lower, if at all, but they can stay surprisingly low for longer than most people predict, especially while the euro overhang persists." Read more: Why you shouldn't dump bonds in 2012.
So bond investing nowadays can be confusing, reflecting the uncertainty about global economic health and the direction of interest rates. Your strategy has to reflect your outlook, as well as be nimble and open-minded enough to find yield opportunities in less-traditional areas.
With that in mind, several bond-market experts were asked to comment on the best ways to approach various bond investments if the bull market takes a breather in 2012, and they offered this advice:
If you believe world markets will remain chaotic and are concerned about geopolitical unrest, then add Treasurys, Rowen said. But if you think there will be improvement, he suggests lightening up on government bonds in favor of better opportunities in stocks and investment-grade corporate debt.
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