From the December 2010 issue of Research Magazine • Subscribe!

The Bond Bubble Debate is On

Bond markets have been on a tear. But given conditions in the economy and recent measures taken by the Federal Reserve, experts say, it may be time to take a fresh look at existing fixed-income holdings and consider alternative holdings.

“The ‘lost decade’ for equity, two grueling bear markets and an aging demographic have investors running for cover in fixed income,” said Chris Dillon, a portfolio specialist with T. Rowe Price, in a recent presentation he made in Phoenix during Commonwealth Financial Network’s national conference.

While many investors have focused on five-year Treasuries, “Diversification into higher yielding ‘spread’ sectors warrants consideration in the current environment,” Dillon explained.

Select municipal and corporate bonds have an “interesting” story to tell these days. Some BB-rated high yields, he points out, have a yield spread of 480 basis points (or 4.8 percent) over Treasuries. And emerging-market corporate and local bonds are also worth consideration. About 70 percent is investment grade, and that figure should rise to 80 percent as Turkey’s debt is upgraded. “Emerging-market debt is becoming attractive to pension funds,” Dillon said.

Taking a historical perspective, “We are not necessarily in a bond bubble,” Dillon said. But there are some issues that warrant further consideration in the fixed-income arena, he adds, especially with respect to U.S. Treasuries, which “quite possibly” are in a bubble. “The yield curve is flattening, and things can unwind quickly,” Dillon explained.

Traditional high-yield bonds generally perform well when rates rise, with some exceptions. And the same is true for investment-grade municipals, Dillon says. “When it comes to U.S. high yield and emerging-market debt, there is still some value left,” he noted.

In municipals, “Risk has been re-priced into the market,” Dillon explained, which has his team targeting bonds rated AA or below.  “Without a double-dip recession or deflation, there is little value in Treasuries or AAAs.”

Other fixed-income investments of interest to T. Rowe are select floating-rate notes and bank loans, as well as California Economic Recovery Bonds.

Stephen Rudolph of HW Financial Advisors, an RIA affiliated with Commonwealth Financial in Cleveland, however, believes it’s important that investors understand that bonds may be safe in some respects but won’t produce adequate returns for the long term. For instance, the many higher-quality bond funds have yields of only around 2 percent.

Advisor Perspective

“Given that we do not see much return left in bonds and that they are not risk free, we are aggressively selling corporate bonds,” he said during the Phoenix event.

There’s a lot of emotion involved in the current wave of bond buying, which is seeing inflows of $5 billion to $10 billion a week, he points out. “Bonds have done well the last 5, 10, 20 years, but that’s chasing past performance and the sign of a massive bubble,” Rudolph explained.

When interest rates start moving up, it is possible that investors in bond funds could actually lose money even after accounting for the interest on the bonds, he says. “If interest rates spike up dramatically, these losses could surprise a lot of people that think they are being conservative and are trying to protect themselves from losing money. This is because bond prices tend to move in the opposite direction of interest rate moves,” said Rudolph.

Thus, the advisor is looking at floating-rate bond funds, which should perform well with interest rates at 4 to 6 percent. And he’s discussing high-quality dividend-paying stocks with his clients.

“I have never seen a time when you can get a higher yield on high-quality dividend paying stocks than what their bonds pay,” Rudolph explained. “Additionally, unlike bonds, most of these companies increase their dividends every year, providing some inflation protection. Many of these stocks look attractive vs. their bonds, and they also are very global in scope.”

Plus, he’s focusing on hedge funds and alternative-strategy funds offered in a mutual-fund format ­— those funds that have a low correlation to stocks and bonds, such as long/short funds, merger arbitrage, market neutral funds, commodities, etc.

“People are so scared that they do not want to risk losing money. The paradox is that if you earn nothing on your money, you are likely to lose around one-half of your purchasing power over the next 15 years or so due to inflation. How is that safe? Perhaps the bigger risk is that people may outlive their money, because they were too conservative after stock market crashes and perhaps too aggressive after big stock market rallies,” shared Rudolph.

Furthermore, although Rudolph doesn’t like to hold cash, he says he is willing to hold some from bond proceeds to utilize as “future opportunities present themselves.”

It’s also important for clients to look carefully at the funds and bond holdings in their 401(k) plans, he shares, and be sure that they’re not chasing historical returns. “Some funds that did worse in the 2008 bear market ended up doing the best in the recent recovery,” the advisor said. “Compare funds to similar funds in their category, so that you aren’t chasing the hot category.

“Look at something called the batting average to see under the current manager how many years the fund has outperformed similar funds. So, if a fund beat the average fund in the category for seven of the last 10 years, his batting average would be 0.700. This helps to find a more consistent fund vs. a fund that had one huge year and led the fund to have a good track record, perhaps by luck,” Rudolph explained.

Varied Bond Views

The Federal Reserve’s second phase of quantitative easing, announced on November 3, “further pushes the Treasuries into overvaluation,” said Barry P. Julien, managing director of fixed income for First Western Capital Management in Los Angeles, during a phone interview. “There’s also a moral hazard issue that is further exacerbated with many investors not properly evaluating risks in the market and being too comforted by the Fed.”

Though valuations are becoming further stretched, he says, it’s not yet a bubble. “Clearly, we will see the Treasury yield curve steepening more as the Fed does all it can to push up inflation expectations, which is what it wants to do.”

Julien adds that he believes the Fed’s move is in effect pushing investors into riskier products, because of the unattractive yields on U.S. Treasuries. “Thus, you must know your risk tolerance. And if you [or your clients] need 5 percent for income, you may have to go out of your comfort zone. Other products can have greater maturity or credit risk.”

As a result of this scenario, his view is that we aren’t in a bubble but are facing “tons of risk, duration risk: As interest rates go up, you could see a loss of 30 percent-plus in the principle value,” Julien explained. “And some investors may not be evaluating that properly.”

Pimco’s Opinion

Bill Gross, Pimco’s founder, managing director and co-CIO, says — when it comes to bonds — the times are indeed changing, now that the Federal Reserve has announced a second round of long-term Treasury bond purchases to the tune of $600 billion, referred to as QE2. “The Fed’s announcement will likely signify the end of a great 30-year bull market in bonds and the necessity for bond managers and, yes, equity managers to adjust to a new environment,” he wrote in a November commentary.

“Bondholders, while immediate beneficiaries, will likely eventually be delivered on a platter to more fortunate celebrants, be they financial asset classes more adaptable to inflation such as stocks or commodities …,” Gross added.

The Fed’s bond buying “raises bond prices to create the illusion of high annual returns, but ultimately it reaches a dead-end where those prices can no longer go up. Having arrived at its destination, the market then offers near 0-percent returns and a picking of the creditor’s pocket via inflation and negative real interest rates. A similar fate, by the way, awaits stockholders, although their ability to adjust somewhat to rising inflation prevents such a startling conclusion,” he explained.

On a positive note, however, he says there are other ways to invest, which he calls “safe spreads:” developing/emerging market debt with higher yields and non-dollar denominations, along with high- quality global corporate bonds. “Even U.S. Agency mortgages yielding 200 basis points more than those 1-percent Treasuries, qualify as ‘safe spreads,’ ” Gross explained.

“While our ‘safe spread’ terminology offers no guarantees, it is designed to let you sleep at night with less interest rate volatility,” he added.

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