Don't Get Crushed by This $376 Billion Bubble

Wall Street may be to blame for the last bubble, but this new bubble is all our fault, people. And we're going to pay for it.

I'm talking about the bubble in bond funds.

Fool me once ...
Individual investors are disenchanted with the stock market. I get it. What was preached as the place to park your money for the long term just underwent a decade of negative returns. Purportedly "strong" companies like General Electric (NYSE: GE  ) and Bank of America (NYSE: BAC  ) were nearly taken out. It hurts. It burns. It makes you want to run for your life and never touch stocks again. That's the attitude many investors took.

But every dollar yanked from the stock market needed a new home. Since bank accounts achieve nothing, and the space under your mattress even less so, this homeless cash charged bum-rush-style into what seemed like the best alternative: bond funds.

And why not? Bonds are safer than stocks, our college professors told us. Gentlemen prefer bonds, the history books tell us. You want to play it safe, you stick with bonds, right?

Not this time
If there's one golden rule to investing, it's this: Any asset can become overpriced, underscrutinized, and excessively loved. It happens over and over again, and it invariably leads to the same result: The most loved assets lead to terrible long-term returns.

To get an understanding of how much love has shifted from equity funds to bond funds over the past three years, consider this table:

Year

Equity Fund Flows

Bond Fund Flows

2007

$91.3 billion

$108.5 billion

2008

($233.8 billion)

$27.1 billion

2009

($9.3 billion)

$376.3 billion

Source: Investment Company Institute.

Focus on the $233 billion mad dash out of equities in 2008, and the even larger $376 billion charge into bond funds last year. This see-sawing tells us that there's more euphoria in bond funds today than there was panic in stock funds during 2008. Indeed, last year's bond inflows more than doubled the previous all-time record set in 2002.

Never met a bubble they didn't love

Now, bonds had a terrible 2008, so 2009's rush was partially chasing after a great opportunity. This wasn't all dumb, blindfolded money. But there's reason aplenty to believe the bond bonanza has gone too far:

  • In late January, the yield on one-month Treasury bills turned negative for the first time since last March. There's so much demand for bonds that investors are willing to deliberately lose money. Seriously.
  • The spread between corporate bonds and long-term Treasuries might look generous today. But the Federal Reserve purchased hundreds of billions of dollars worth of Treasuries over the past year. That kept Treasuries' yields down substantially. So the actual spread on corporate bonds is probably tighter. Translation: Bonds are more expensive than they look.
  • The Wall Street Journal recently reported that "it has become more expensive to buy protection for the debt of a range of countries than it is to purchase similar protection for some companies in those nations." This could be because investors are worried about federal deficits and sovereign debt overload. Or it could be because they're unreasonably optimistic on corporate debt. Take your pick.

But beyond these anecdotes, the obvious threat hanging over bonds is interest rates.

We're in a unique situation right now: The Federal Reserve has short-term interest rates pegged at zero, and it just finished purchasing trillions of dollars of longer-dated fixed-income assets (like mortgage-backed securities). Add that it an economy on the mend, and you have a solid foundation for interest rates that are very likely to rise, and in some cases are mathematically barred from going lower. And since bond prices are inversely correlated with interest rates, prices go down when rates go up.

Translated in English: Interest rates will rise. Bonds are bound to fall. Yet investors are flocking to them in unprecedented droves, where they'll be met with long-term returns approaching bupkis.

What to do, what to do...
Rather than driving headlong into bonds, where should investors put their money? For me, the choice is easy. I favor large-cap, high-quality stocks with:

  • High dividends.
  • Moats that create pricing power.
  • Businesses that don't rely on discretionary spending.

Here are five I've got in mind:

Company

Current Yield

Altria (NYSE: MO  )

7%

Verizon (NYSE: VZ  )

6.6%

Southern Company (NYSE: SO  )

5.6%

Reynolds American (NYSE: RAI  )

7%

McDonald's (NYSE: MCD  )

3.5%

You could counter that rising interest rates hurt stocks and bonds alike. This is true in most cases. But all five companies listed here have pricing power. They can liberally increase prices when need be, combating the effects of inflation and rising interest rates. Bonds can't.

That's one of the main theories our Motley Fool Income Investor service stands behind. The team picks two dividend stocks per month, tells you why they think they'll outperform, and lets you banter back and forth with both the analysts and thousands of fellow investors. To date, the team's picks have outperformed broad market indices by more than 7 percentage points per pick. Click here for a free 30-day trial. There's no obligation to subscribe.

Fool contributor Morgan Housel owns shares of Altria and Verizon. Southern Company is a Motley Fool Income Investor recommendation. The Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (33)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 12, 2010, at 4:37 PM, langco1 wrote:

    some more news on the recovery in the US. 1 in 8 americans are now on food stamps.thats a real sign of how well the country is doing..the american people need to end this disgrace and they can start by putting obama and his family on food stamps. it is time to demand a midterm election and bring in someone less interested in being a small time celebrity than running the country...

  • Report this Comment On February 13, 2010, at 9:25 AM, twinklejenny wrote:

    Dividend Aristocrats are companies in the S&P 500 that have increased dividend payouts to shareholders every year for the last 25 years:

    http://www.TopYields.nl/Top-dividend-yields-of-Dividend-Aris...

  • Report this Comment On February 13, 2010, at 12:30 PM, langco1 wrote:

    google the online phone book has become so desparate to maintain its failing status that almost every day it comes out with its own version of its rivals better ideas.google is burning up its money chasing behind other companys but does not even realize you cant get ahead by following! googles founders have seen the writing on the wall and have begun massive sales of their stock holdings...

  • Report this Comment On February 13, 2010, at 5:39 PM, elitemind wrote:

    hhhmm didn't see anything in the article related to food stamps. all i see is big companies on roller coasters rides, and people trying to put there money into the next big cash cow..

  • Report this Comment On February 14, 2010, at 5:20 PM, goalie37 wrote:

    Thank you, than you, thank you for this article. The bubble here is so ridiculous, but once again nobody is seeing it. The fallout here will be serious.

  • Report this Comment On February 14, 2010, at 11:44 PM, CatFoodMoney wrote:

    Thank you Morgan. I enjoyed that article a lot. It put a lot of things into perspective for me in a way that I had not yet been able to grasp.

  • Report this Comment On February 19, 2010, at 10:27 PM, daodell33 wrote:

    Great article. But is there a difference between govt. bond and corporate bond funds? Will all bonds go down as interest rates go up or will corporate bonds of those same companies perform well. I would think corporate bonds would fair much better because companies (unlike govts) are more fiscally responsible and generally internationally diversified. Please comment.

  • Report this Comment On February 20, 2011, at 8:39 PM, TimoDOZ wrote:

    Funds are funds are funds.. individual bonds will mature at par and give you a specific YTMaturity. Bond funds get diluted as rates rise more investors pouring in as the bond values drop the yield rises and new investors come in the bond fund by the definition is not a cash position equity and will reinvest new fuinds at the higher rates. If rates continue to rise you have a larger pool of capital then being diluted and more money coming in which again gets put into new or secondary bonds that are getting discounted to reflect the higher yields. Your cost basis remains at a higher cost so you do not see the higher rates of return the new investors are getting partially from the bonds that the fund held when you bought in. those bonds of course no longer having the same value as they did in terms of your cost basis. There are some bullet fund ETFs that somewhat mitigate this dilution with prescribed fund end dates and bonds that are not beyond a certain year of maturity. To invest "safely " in a rising interest rate environment you need to use a long end Barbell for yield and a short end to protect principal. you hope the long bonds have high enough rates to never have rates catch up, so with their high yield they will provide a total positive return. The Bond ladder of 2-5 year maturities works well as well but generally will not initially produce as much income but long term may provide a better total return. The theory being in the time (2 years) you may take to assemble such a bond ladder the longer 5-6 year maturities wil be rising in yield so that as the lowest yielding short term maturities mature they are then re-invested total principal intact into higher yielding longer term maturies. The maturing bonds in a rising rate envirionment always get reinvested generally at a longer term higher yield depending on the quality of the issuer. Generally " investment grade quality" bonds. The bond bubble is going to end badly when the global markets, the $20 trilion in Total state and national debt, eventually connect with reality. In two years of QE currencies like the Swiss franc and Canadian Loonie have advanced 20% against the US Pe$o. Some thing like what happened in stocks when the 40 to 1 leverage of the banking and insurance institutions blew up is in store for the bond market. In 1978 the average American couple considered themselves fortunate to be able to buy a house with an 11.25% 20 yr mortgage. Mortgage rates ultimately went to the 18% level during the post Vietnam War great inflation. Vietnam another war that the politicians of the time thought they did not have to pay for with tax receipts. A third option is to invest in an asset class called closed end funds where bonds can be purchased in a bond fund at a significant discount to the actual market value of the bonds. Some of these funds like a EXD sell at steep discounts and pay 10% distributions. Not all of the distributions however comes out of the bond earnings and there are other issues like return of capital that might complicate your tax situation. If you invest in something like that or other bond funds then you can put some amount of say near 20 -25% of the total investment in a inverse bond etf and some are leveraged to make them cover more of your long exposure in the bonds. 20% in a TBF unleveraged and 10% in a TBT double leveraged can insulate your total principal in the bond funds from interest rate risk. Another option is some really good convertible bond funds where there is some particip[ation in the stock market by some portion of the bond. The bonds generally having a conversion parameter where they are either called, converted mandatorily or based on the value of the underlying stock. The FCVSX is an excellent one but did not preserve principal as well as a INCMX or PRPFX. NGZ is another very good convertible fund with international hard currency exposure.

    Plain bond funds are at this point all very dangerous investments. With pension reforms for public pensions pending in states like

    Wisconsin and NH where there would be consequences to the distributions independent of a requirement for further tax payer funding to the state pension plans that do not achieve their actuarial rates of return as defined for their trusts by the trustees and fail to be at least 80% funded, there may be some recovery in the muni bond market that may be over sold? It is clear that newer muni bond funds may soon launch that will be devoid of bonds from the so called troubled states like Calif, Illinois, Fla, NY NJ GA etc. Some of those state's bonds may yet be solvent in cases where they are revenue rather than general obligation bonds. If a few states adopt these new laws and measures that at least define a limit on state's unfunded pension obligations the others will be had by the b411s and their hearts and minds will follow to avoid being put at an unfair competitive business environment. If you sold all your bond funds in the first week of Nov and tranched into some precious metals etfs like AGQ, GLTR, PALL, and WITE dring the ensuing PMs pullback you might be 20% ahead of where you would be if you stayed in the bond funds. So it is important too consider that there are appropriate times to rotate out of one asset class into another. I find EXD currently quite appealing but it also might be a bear trap that sees it's share price drop another 10% and the managers decide on a distribution adjustment? In the same 10-12 weeks GDPAN a convertible not quite a bond has soared. There is only risk,credit quality risk, interest rate risk market melt down risk that takes every thing including good investment quality investment bonds down too. But then if they are of good quality they wil eventually mature at par. Bond funds like open ended mutual funds just do not eventually mature. Not many stock mutual funds have recovered 100% of their previous record nhighs, 80% of the stock funds are still down 20% even though the market is up 95% off the bottom. Individual bonds do not have 12-b 1 fees and management fees. On Monday 2/14 Bill Gross one of the worlds great bond fund n\managers announced that he had reduced US gov't bondss to 10% in his total return fund. He remarked that "low rates for Gov't bonds cheat investors".

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