They’re not sexy or exciting.
They’ve got a face value that only a mother could love.
But they may be ground zero of the next economic Waterloo; and we may not see it coming until it’s too late to do anything about it.
Since the precipitous fall of the stock market back in 2008, investors have been throwing their money into government bonds and the safest corporate bonds they can find. These investors may not be getting the big returns to which they previously were accustomed, but at least they’re relatively confident they’ll get their money back.
These expectations, however, may be a tad premature.
Over the last year, net inflows into fixed income investment vehicles like bonds have outpaced equities by nearly tenfold. According to the Investment Company Institute, bond funds saw $375 billion of inflows in 2009 and the trend is continuing in 2010. So far this year, an estimated $380 billion has been poured into bond funds.
All Investments Vulnerable
Despite the fact that historically low interest rates severely limit their returns, this rush to the perceived safe haven of the bond market has continued to push bond prices higher. As we learned from the tech and housing bubbles, no investment is immune from steep corrections and nothing is a really as safe as it appears.
At the present time, with the economy still being slack and inflation relatively low, the Federal Reserve has been able to hold pat on interest rates. Because unemployment will likely to continue hover near 10 percent through the rest of this year, and well into the next, interest rates will probably remain at or near these levels through 2011.
If this recession has taught us anything, it’s that nothing lasts forever, including low interest rates. The Fed and its Chairman Ben Bernanke are already pondering an exit from all of the money they’ve pumped into the economy and a strategy to head off the inflation risks these policies have created.
To fight these inflationary threats and tighten its own balance sheet, the Fed will have no alternative other than to raise interest rates. This rise in interest rates will undercut the market or resale value of the bonds currently being held. Put another way, when interest rates go up, and potential bond purchasers see the prospect of better returns from these newer instruments, they will be less inclined to buy any of the bonds that already have been issued.
This problem is compounded by actions the Fed will have to take with a U.S. federal deficit that soon will surpass the $1 trillion mark. To deal with this red ink, the Federal Reserve will have no choice other than to print dollars to increase the money supply. When this happens, increases in the consumer price index will eat away at the yields and real returns on bonds.
Beware of a Dark Cloud
Savvy bond managers, like Pimco’s Bill Gross, are always trying to stay ahead of the so-called yield curve. They understand their job is an economic version of musical chairs. They don’t want to be the last guy standing when the music stops.
Although bond managers may not know precisely when interest rates will rise, they know it’s going to happen, and will start to act preemptively by liquidating their portfolios. This selloff will put an additional damper on bond prices, and further spur bond managers to push bigger sales in order to meet redemption demands from their investors.
The effect may not be as dramatic or as easy to comprehend as the disintegration of the housing market. But for investors who have already fled the stock market, these losses in an asset they thought was otherwise safe will be like rubbing salt into their financial wounds.
During the depths of the Great Depression, cowboy comic and folk philosopher Will Rogers once quipped, “Don’t tell me about the return on my investment; tell me about the return of my investment.”
For the millions of investors who have flown the stock market for the safe embrace and supposed certainty of the bond market, the dark cloud they see in their rearview mirror may be a lot closer than they think.
John Cohn is a senior partner in the Globe West Financial Group based in West Los Angeles. He may be contacted at www.globewestfinancial.com
