Monday, September 20, 2010

Bubble, Bubble, Trouble in Bonds?

Boomers should probably pay attention.  What is or better what could happen in the bond arena will impact not only what you know about your potential retirement wealth but whether your retirement wealth can withstand what may happen.

Personally, I don't like the term bubble.  It implies that once punctured, the pop is immediate.  But that's not how market bubbles usually react.  There is the slow hiss of the initial investors leaving somewhat quietly, who begin to see that things aren't going as planned.  This of course follows the big investors making statements that make sense, are largely ignored and then, suddenly embraced and the selling begins. The next to bail on the bubble is the individual investor who may have used that certain security as a parking place for their money or even as a short-term investment.

Following that, the retirement investors.

All the while the value of said bubble decreases. It doesn't "pop" as bubbles do but instead offers pain to those slow to react. The warnings are starting to surface at a more frequent pace and if this is a typical bubble scenario, those who went conservative after losing a great deal of their portfolio value in the last market debacle and began investing in bonds will be the last to react.  And be the worst hurt.

Many folks invest in bonds as part of an aging portfolio rebalancing.  In numerous cases, they do this via bond mutual funds and not the individual kind.  Unfortunately, this carries some additional risk.  Individual bonds have fixed maturity dates.  If held until that point, they will do exactly as they promised, paying you whatever the coupon book suggests.  That is, unless they default at some point.

Bond mutual funds, like all mutual funds are a basket of bonds with varying maturity dates.  Your reliance on the mutual fund manager to have a good mix, be wary of maturity dates and offer some considerations for the potential of default (when a bond is not bale to pay the value of the bond, which is essentially a loan).  But even more, the length of those bonds in the portfolio might be at risk as well.

Bonds have seen a lot of new fans.  Investors worried about not having enough to retire on, worried that the markets betrayed them in 2007-2008, and the concept that retirement as originally planned will need to be re-thought, even reconsidered, saw a great deal of rebalancing.  This "rebalancing may have been just as unbalanced as an equity heavy portfolio was - and what got them into trouble in the first place.

The old idea that your bond allotment match your age has found many investors poised to be disappointed, if, what the bond gurus are saying comes to pass.  And what they say is not good news. Bill Gross, the king of PIMCO sees trouble on the horizon. And yet, you hold on for more proof that the one man who probably knows everything there is to know about bonds is right. By then, it will be too late for many investors.

So why is he, and numerous other experts worried? There are several reasons, one of which I already mentioned: default. We hear numerous reports of how flush many businesses are with cash.  While there are quite a few with huge reserves, enough to worry the White House and economists alike, there are many more who simply must go to the bond markets to continue to finance their operations.  While this seems like a good idea on the surface, worries about the prolonged nature of the recession have also raised fears that many of these bonds will not be repaid.

Untangling this sort of mess in a mutual fund environment can be the most difficult.  And when investors catch wind of this possibility, fund mangers begin to sell to cover those departing the fund.  From there, its is a quick tumble towards the bottom for those remaining and the bond markets in general.
Inflation is also a concern.  This has been more or less benign of late.  Yet no one expects it to remain that way, new bond investors may not have the savvy to recognize the negative effect of this on their portfolio.  As inflation rises, the money involved in the bond - which is fixed in terms of how much is owed to you and the yield you expect - is worth less.  Not worthless, but not worth as much as you might assume it would be.

Ty A. Bernicke, writing in Forbes sees trouble on the horizon in the form of interest rates.  The Federal Reserve could hold rates low in the near term.  But don't expect it.  He writes: "There are three striking similarities between the 1940s economic landscape and today. The U.S. is experiencing an extremely low interest rate environment, our country is coming off a prolonged period of low inflation, and there are elevated concerns regarding defaults on bonds. The same three factors were present just prior to the beginning of the prolonged bear market in bonds from 1940 to 1980." In 1980, we began a bull market in bonds that has lasted until today.  There is evidence that this is beginning to unravel.

If that happens, we could be in for a long stretch of not much of anything.  beginning in 1940, and lasting for forty years, the "five-year government bonds averaged 3.38% per year" and "corporate bonds with maturity dates near 20 years averaged 2.8% per year".

There are only a couple of things you can do if you have invested heavily in bonds or bond funds.  Begin rebalancing now, lowering your exposure to these securities.  Some younger investors have far more than the traditional rule of thumb suggests (percentage of bonds equal to your age) and older folks should pay heed as well.  You could look towards the stocks that paid dividends consistently throughout the downturn.
Dividends paying mutual funds tend to be the most stable, spreading the investment over a wide swath of the top 100 or so companies that pay.  That's not to suggest that you couldn't buy the dividend paying stocks yourself, individually.

The only other thing might be to go short-term and look for the highest interest rate.  This will take a little bit of homework on your part.  But your investments will be somewhat safer, more liquid and not among the casualities that are bound to be tallied by this time next year.

Paul Petillo is the Managing Editor of and a fellow Boomer

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