They say bad things come in threes, and in the past decade investors have seen the bursting of two market bubbles. Now some money managers believe a third is in the making -- in bonds.
And just as previous losses were made worse by investors rushing headlong into assets that showed signs of overheating, bond prices are being inflated by investors pouring in cash at record rates.
Yet unlike the technology- and credit-fueled bubbles, which resulted from eager buyers chasing returns, this latest bubble is forming in part because frightened investors want to minimize risk and avoid further losses.
After the fall of technology stocks in 2000 and the financial crisis of 2008, many investors shunned stocks and headed for the perceived safety of fixed income. But that stampede into bonds, coupled with changes in the economy, threatens investors with losses in their longer-term bond funds.
That's because interest rates will likely rise from today's base of almost zero. Higher rates slam bond values. But investors mostly know only what they've seen in the past 25 years: generally a period of steadily declining interest rates and rising bond prices.
"It's fallacious reasoning that you can't lose money in bonds," said James Swanson, the chief investment strategist at MFS Investment Management. "Even Treasurys lost some of their principal during the first half of 1987."
Ignoring the danger?
But some bond fund investors seem oblivious to the danger, in part, perhaps, because bond funds have not sustained significant losses in recent years."A multiyear move of rising interest rates is an environment that most people haven't seen before," said Tom Atteberry, a co-manager of the FPA New Income (FPNIX) fund.
From 1985 through 2009, bond fund returns, on average, dipped into negative territory just three times, with losses of 4.7% in 1994, 1.2% in 1999 and 7.8% in 2008, according to investment research company Morningstar.
U.S. stock funds, by contrast, had six losing years in that period, including tumbles of 12% in 2001, 23% in 2002 and 39% in 2008.
"People are conditioned to push the 'fixed income' button (in times of trouble), because for nearly 30 years you didn't have to do anything to make money," said Bill Eigen, the manager of JPMorgan Strategic Income Opportunities (JSOAX), a bond fund with a flexible, go-anywhere approach.
In 2009, bond funds saw a record $375 billion of new money come in, ending the year with $2.2 trillion in assets, according to the Investment Company Institute. By contrast, domestic stock funds saw $40 billion go out the door, ending the year with $3.7 trillion in assets.
A relatively long term
Many investors may be surprised to hear that bond funds could be so vulnerable, in part because if one holds a bond to maturity, the full principal is returned.Not so with bond funds, which typically don't hold bonds to maturity. A long-term bond fund, for example, needs to keep its average holding maturity several years out, in part to keep yields up, so it cycles through bonds. Fund flows also play a part; managers often need to buy and sell securities depending on the cash going in and out of the fund.
Interest-rate increases may be many months away, but higher rates could spell trouble for bond fund managers as demand for lower-yielding securities becomes scarce and prices fall.
It's not just about rising rates. If -- or when -- inflation pressures build, even bond funds posting modest gains will end up losing money in real terms.
