The New Bond Bubble

AGA7d

6/10/2010

Christopher Van Slyke has an unusual dilemma for a financial planner: He won’t sell the investment many of his prospective customers now want to buy. About a year ago, he started getting a stream of potential clients coming into his Los Angeles office wanting “risk-free” portfolios stuffed with bonds. He’s not opposed to bonds per se, but in recent months he has taken a dim view of a once dull but steady investment product. Yet the requests keep coming. For municipal bonds. For corporate bonds. For bond funds. And Van Slyke still keeps saying no, even after a local branch of the broker TD Ameritrade stopped recommending customers to him. “I’m not going to let you hire me to build a bad portfolio,” Van Slyke says.

In the late 1990s, it was tech stocks. In the middle of this decade, it was real estate. And today bonds are the investment people can’t seem to get enough of, unlikely as that may seem. Lured by their perceived safety—not to mention some spectacular deals, the kind unseen in decades (read: 15 percent yields)—investors plowed $313 billion more into bond funds than they took out in the first 10 months of 2009. That’s a staggering amount considering that over the same time investors withdrew about as much money as they put into stock funds. But in a remarkably short period, a lot of those fantastic bond deals have faded away, with a good many bonds now yielding half what they did last summer. And while a return on a corporate, municipal or Treasury bond might look better compared to a bank account (then again, what doesn’t?), many bonds are carrying a lot more risk. When some investing pros look at the bond market and the frenzied demand for fixed income, they do not like what they see. “It has a bubble look to it,” says Thomas Atteberry, manager of FPA New Income, one of the largest independent bond funds.

Not all investing pros see it this way, of course, and most continue to advise that some bonds should be included in investor portfolios. Still, some legends in the bond world have started to worry that if a bubble were to burst, it wouldn’t be too far off. (For one bond veteran’s view, see page 45.) A bond bust might not be as obvious to ordinary investors as a stock-market crash; there likely wouldn’t be the Pets.com-style flameouts we saw in 2000. But when they happen, bond debacles can have an insidious effect on people’s nest eggs. If interest rates were to rise, for example, and many analysts believe that’s a likely scenario, bond prices could get clobbered. Prices on even “safe” Treasury and As with many investing manias, there were some good reasons to dive into bonds early last year. During the financial crisis in late 2008, many hedge funds and financial institutions found themselves in a crunch and had to sell all sorts of bonds fast to raise cash. Bond prices fell dramatically, and some savvy bond investors smelled opportunity. By December 2008, some pros were buying bonds of high-quality companies, such as Johnson & Johnson, paying 7 to 10 percent interest annually for 80 cents on the dollar or cheaper. Those who wanted to take on more risk could buy bonds from financially strapped states that offered 11 percent after-tax returns or corporate “junk” bonds with annual yields of 20 percent or more. Fantastic deals persisted for months (SmartMoney wrote about them in April 2009’s “The New Bond Boom”). Financial planners and brokerages began recommending adding bonds, too. For the most part, it was great advice. Overall, corporate bonds returned 10 percent in the first 10 months of 2009. Junk bonds were up 51 percent.

But the simple law of supply and demand has pulled bond yields back considerably. Junk bonds have seen their yields cut by more than half. And the yield on the 10-year Treasury is barely half its average of the past 50 years. Some big bond investors are looking to move away from them. Last fall Allstate, the insurance company, sold off about 10 percent of its $23 billion portfolio of municipal bonds. Muni bonds did well in 2009, Tom Wilson, Allstate’s chief executive officer, told analysts in November, but he’s worried about the budget deficits states and towns face. Nevertheless, it’s those spectacular short-term returns that keep attracting many individual investors. “It’s performance-chasing and following the herd,” says Michael Liersch, a professor at the New York University Stern School of Business.

Investors also have gotten a push from the financial industry. Many brokerages started touting bonds right after the crash, but they’ve continued to pitch them as bond yields drop. Fidelity, for example, sent an e-mail to clients in October asking them to consider adding emerging-market bonds to their portfolios, pointing out that they were up 26 percent in the first nine months of 2009. They’ve been about flat ever since. (A Fidelity spokesperson says the e-mail discussed both the opportunities and the risks of emerging-market bonds.) In mid-November, Morgan Stanley’s head of fixed-income research, Greg Peters, went on CNBC, pushing people to buy some of the riskiest, “junkiest of the junk” corporate bonds even after admitting that “the easy money has been made.” (A Morgan Stanley spokesperson says Peters’s advice wasn’t geared toward retail investors.) Brokers, of course, get a commission on each bond they sell—usually between 1 percent and 1.5 percent, often much higher than for a stock trade. And that adds up quickly: Based on 2009 data, fund companies stand to earn at least $2.6 billion more than they did in 2008 from sales of bond funds, whether bonds make or lose money.

How many of those managers will explain bond risk to customers is anyone’s guess. When the Federal Reserve thinks the economy is well on its way to recovering, it will raise rates—perhaps even raise them quickly. What’s more, bond investors have to keep an eye on the companies and governments that issued bonds. Some firms get into so much trouble, they can’t pay the interest or principal on the bonds they’ve issued. When that happens, the company defaults, and bondholders could lose half their investment or more, analysts say. State and local governments aren’t in the clear either. State tax revenue, a common source of financing for municipal bonds, was down 11 percent in the third quarter of 2009, and unlike the federal government, states and towns can’t print more money. Defaults in major municipal bonds are extremely rare (the last high-profile default was in 1994), but they’re not unimaginable.

Regardless of bond prices and yields, all bond returns will look worse if inflation comes back. To combat the recession, the federal government has thrown trillions of dollars into the economy, running up the 2009 budget deficit to $1.4 trillion. Many experts say it’s nearly inevitable that all that money sloshing through the system will eventually lead to inflation—which in turn will eat away at the purchasing power of a bond’s interest payouts. Investors often overlook the risk that they will effectively get “poorer and poorer every year,” since their fixed-income payments usually aren’t adjusted for inflation, says Van Slyke, the financial planner.

To some degree, financial planners also helped stoke the bond craze. For years advisers held up bonds as the way to diversify and lower risk. For his part, Van Slyke says he cajoled many clients to buy bonds, only to meet stiff resistance. Some planners are now trying to tone down the mania they, in part, helped create. Roland Manarin, an Omaha-based money manager who in the 1990s advised clients to stock up on bonds, now tells clients who insist on a guaranteed return to buy annuities instead. He’s not shy about just how strongly he worries about bonds, either. When he’s not behind his desk, he can be found lecturing at libraries, on his Sunday radio show, or in Phoenix, where many of his clients have retired, saying the same thing: “Bonds could be worth zero at any moment.”municipal bonds could fall 30 percent or more if interest rates soar over the next few years; some corporate bonds could fall even more. “Even with government funds, people forget you can lose money,” says Carol Clark, investment principal at Lowry Hill, a money-management firm in Minneapolis.

To be sure, if a bond’s price falls, instead of selling the bond at a loss, the investor could just sit and collect the interest it pays. That wouldn’t be a stretch for most people; an overwhelming majority of individual investors hold their bonds until maturity, according to BondDesk Group, a fixed-income broker. But doing that means holding a bond for years, perhaps decades. The 4.7 percent annual interest a current 20-year Treasury bond is paying might look good now compared with a bank CD, but it’ll seem mediocre in five years if interest rates rise and banks start offering 7 percent CDs—while you’re stuck until the bond matures in 2030. Bond mutual fund owners don’t even have a say in whether or not to hold their bonds. Their funds can lose money, and in late 2008, when the credit markets froze, the average bond fund lost 12 percent, according to Morningstar.

Individual investors, however, keep jumping into the bond pool. As late as October, when most of the best bond deals were long gone, investors were calling up their brokers to get in on the bond craze. In fact, that month they bought nearly $88 billion in bond funds, or about $118 million an hour. That includes people like Hemang Shah, a Virginia Beach, Va., neurologist who sees bonds as a way to get safely to retirement. By his own admission, bonds aren’t as attractive as they once were and carry new risk. But he recently told his financial planner to increase his bond holdings by 50 percent because, he says, he’s unable to shake the memory of losing so much of his savings: first to the 2000 tech bubble, then to the real estate bust, and most recently, to the market crash. “It was money I earned day by day, working my butt off, that I lost,” Shah says.

Bonds, of course, are not the most straightforward of investments. Trying to explain how bond prices work (they usually go down when interest rates go up, and vice versa) can exhaust even patient financial planners. Looking up an individual bond’s price can be excruciating, often involving remembering not only the bond’s exact name but also its nine-character identification. Nevertheless, many investors still have one thing in mind when it comes to bonds, something drilled into many people at an early age, when they received a U.S. savings bond as their first-ever investment: Bonds are predictable and a lot less risky than stocks. That attitude could now come back to bite people. “Investors in bonds don’t expect risk, and the longer the Federal Reserve keeps rates low, the more complacent people become,” says Lawrence Glazer, managing partner of Mayflower Advisors, a money-management firm.