Time to dump bonds?

By Don Wilkinson

DFW & Associates


Guess what? Another bubble may be coming your way with even more serious consequences for conservative investors. It’s bonds.

If you were around 10 years ago, you must remember the biggest bubble burst in U.S. stock market history. That was the technology craze, with highflying tech stocks selling in excess of 100 times earnings. After it was over, most of the highfliers declined in equity value of 80 percent or more.

Guess what? Another bubble may be coming your way with even more serious consequences for conservative investors. It’s bonds. Bonds are the safe and secure investment investors have been accumulating for decades to warn off the ups and downs of the equity market. Today, in essence, bonds may have reached the end of a 30-year era.

For now, we are talking about U.S. Treasury bonds — routinely the most popular investment vehicle in the bond family among investors. As investors became disenchanted with the stock market, they began pouring money into government bond funds and other fixed income vehicles. In fact, the Investment Company Institute reports that from January 2008 through June 2010, outflows from stocks totaled $232 billion, while bond funds increased capital inflows to $559 billion.

It appears that unlike the bubble of 2000, when investors were too jubilant, investors today are overly pessimistic because of our economy’s shortcomings.

So much so that lately, the appeal of bonds has been so strong that the yield on Treasury inflation protected securities fell below 1 percent and remains so today. Bonds are selling at 100 times their predicted payout, give or take. Sound familiar? The same occurred a decade ago when tech stocks sold at 100 times earnings.

Further, the Fed recently announced a second round of long-term Treasury bond purchases in the neighbor of $600 billion, referred to as QE2.

“The Fed announcement will likely signify the end of a great 30-year bull market in bonds,” wrote Bill Gross, PIMCO’s founder, managing director and co-CIO, in a November commentary release.

Gross said the Fed purchase appears as an attempt to boost bond prices. Value reaches a limit.

“Ultimately, the market then offers near 0 percent returns and a picking of the creditor’s pocket via inflation and negative real interest rates,” Gross said.

And rising interest rates are what bond owners don’t want, because existing bonds become more valuable if interest rates fall. If an investor holds a $1,000 bond yielding 6 percent when new bonds pay just 3.45 percent, his bond is going to be worth a great deal more if it’s sold. When interest rates start to rise on new bonds, the market value of existing bonds falls.

When the yield on the two-year Treasury bond recently fell to 0.7 percent, the thinking seemed to be bonds were too expensive, and other projected factors like rising interest rates and inflation made investors wary of bonds for the first time in 30 years.
But experts' prediction of a bid to sell off didn’t happen — at least not yet. During recent weeks, bonds seemed more attractive due to the crises in the Middle East and North Africa. Rising oil prices have contributed to the possibility of another dip in the economy. This would be a boon on what bond buyers are looking for: slow or declining growth and with it, reduced inflation.

So what to do? High quality long-term bonds are most likely to get hurt when rates rise. In fact, there is a very good chance that this will happen.

As mentioned, many investors keep bonds in portfolios to hedge against stock declines. In fact, many people follow the 60/40 rule of investing.

A better way is to secure tactical managers to replace your bonds. These managers have the ability to be investment flexible during tough market conditions. If conditions warrant, these managers will go to cash or less sensitive loss fixed income vehicles. They also look for opportunity sectors during falling dollar conditions. They can put a portion of your client’s portfolio into precious metals, commodities and/or energy, boosting returns.

The combination of traditional strategic managers combined with short-term tactical managers is a better way to go in 2011 than the old way of a 60 percent investment in stocks and 40 percent in bonds.

Bill Gross of PIMCO announced that his $237 billion Total Return Fund, the world’s largest bond fund, had deleted all U.S. government securities on March 9. Short interest in long-dated bond exchange-traded funds has ballooned since the beginning of 2011. These moves signify interest rates might rise soon, lowering the value of existing longer-term bonds.

Still, we have low interest rates, level inflation and climbing high oil prices denting growth. So it’s a crap shoot for bonds now. Nevertheless, the bond bears are out and becoming bolder.

My advice is, why take a chance with your clients’ money? The combination of long-term strategic managers combined with short-term tactical managers is a better way to go in 2011 than the old way of a 60 percent investment in stocks and 40 percent in bonds. Do yourself and your clients a favor and get them out of bonds.