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Did the Bond Bubble Just Pop?

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Bonds may be the new black for investors, but it looks like fashion trends may be changing in the upcoming season. The massive influx of money into bonds in the wake of the 2008 market decline has been nothing short of astonishing. Investors have stuffed hundreds of billions of dollars into bonds and bond funds in recent years, inflating the sector to its limits. And even though warnings of a bond bubble sounded from many corners of the market, investors' appetites were insatiable. However, new data may be pointing toward what could be the initial stages of the inevitable deflating of this bond market phenomenon.

A change of direction
According to data from research firm TrimTabs Investment Research, the nearly two-year stretch of massive inflows into bond funds has been broken. For the week ending Nov. 17, investors actually pulled $4.3 billion out of open-end bond funds. This is the first outflow from this asset class in 99 straight weeks. According to TrimTabs, the only other period that comes close to comparison is the massive inflow of money into stock funds in the late 1990s, directly before the 2000-2002 bear market, which isn't exactly encouraging for bond investors today. This reversal could be just the first step in a wider move away from bonds.

Now clearly no one can call the top of the market cycle based on one week of fund flow data. Given the degree to which the bond market has been inflated in recent years and the general level of skittishness that persists across the market, though, it wouldn't take much to start the ball rolling and for folks to start dumping their bond holdings.

But even if last week's data are an anomaly and investors go right back to buying bonds, this trend will reverse at some point. So even if we haven't reached the peak of the bond market cycle just yet, we will reach it soon. In my opinion, this is unavoidable. And that means that bond investors may be in for a bit of a shake-up, depending on how fast we come down from that peak.

Action plan
More aggressive investors shouldn't lose too much sleep over turmoil in the bond market. While all investors should have at least a small fixed income exposure to reduce volatility in their portfolio, longer-term investors still have a decade or two or three before they need to rely on the income-producing power of their bond portfolio. That means you've got plenty of time to ride out any bond market volatility ahead.

However, for folks in or near retirement, the thought of a bond market rout is a pretty scary one. So make sure that you've got adequate cash flow for roughly the next five years no matter what bonds do. If you're going to need access to your money in that time frame, the bond market is not the place for it. Move it to a more liquid investment account that won't be affected by market swings.

Beyond that five-year period, your best bet is still to stick with intermediate-term bonds and bond funds. While your bonds will take a price hit when rates rise or when investors start moving out of the bond market, you should still have enough time to recover from any fluctuations, and higher interest rates down the road will mean you can recoup some of your losses in the form of higher coupon payments on newly issued bonds. To that end, broad-market exchange-traded funds like Vanguard Intermediate-Term Bond ETF (NYSE: BIV  ) and Vanguard Total Bond Market ETF (NYSE: BND  ) are good choices for most bond investors.

Taking stock
Of course, no matter what is in store for the bond market in the next few years, investors still need to devote a meaningful portion of their portfolio to equities if they want their money to grow over time. So if you've been keeping money on the sidelines out of fear, put that cash to work! Stocks definitely aren't as cheap as they were a year or two ago, but they are still fairly reasonable by historical measures.

For example, one storied, value-oriented investment team is finding a lot to like in the financial and energy sectors right now. The team at Sound Shore (SSHFX) has allocated roughly 40% of fund assets to these two areas. Management believes Credit Suisse (NYSE: CS  ) has one of the industry's strongest balance sheets and that its healthy return on equity makes it a solid long-term prospect. Likewise, the team sees Bank of America (NYSE: BAC  ) consolidating its market share gains and reclaiming its double-digit return on equity in the future.

In the energy arena, the fund likes Marathon Oil (NYSE: MRO  ) and Devon Energy (NYSE: DVN  ) , which are both selling at P/Es far less than that of the industry average but have solid long-term appreciation prospects. If you're a stock picker, you may find many other similar bargains in these two sectors, or if you want a hand in the stock selection process, you can just buy first-rate funds like Sound Shore, which has beaten 90% of its peers in the past decade and a half.

Of course, given that investors typically move en masse into and out of asset classes at pretty much exactly the wrong times, fund inflows make for a rather accurate contrarian indicator. So while stocks are clearly the better bargains in the marketplace right now, once fund flows start to reverse and we see investors rushing headlong back into stocks and stock funds, that may be a sign to dial back equity exposure and prepare for another stock market pullback. But for now, the risks are clearly greater in the bond market.

Time will tell exactly when investors' enthusiasm with bonds will end and whether we'll be in for a soft or hard landing as a result. But it will happen. That means at the very least, you've got to be ready for some volatility ahead in the bond market -- and prepare for some potential losses as well.

Being smart about bonds is just one key toward a successful retirement. Click here to read the Fool's new special report, The 7 Secrets to Salvage Your Retirement Today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. The Fool owns shares of Bank of America and Devon Energy. Try any of our Foolish newsletter services free for 30 days.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (4) | Recommend This Article (11)

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 November 30, 2010, at 9:43 PM, rd80 wrote:

    Hi Amanda,

    Did the Trim Tabs report break down the taxable vs muni flows?

    The WSJ reported the same $4.3 billion net outflow as you reported from Trim Tabs, but added a breakdown of a $4.8 billion outflow from muni funds while taxable bond funds had inflows of about half a billion.

    Any insight/thoughts on breakdown?

  • Report this Comment On December 02, 2010, at 1:44 PM, TMFBroadway wrote:

    The outflow from muni bonds isn't too surprising, given the surge in issuance lately as well as increasing concerns over state and local finances. But while large outflows may be concentrated in the muni sector right now, I don't think it will take much for macro events and investor skittishness to encourage the trend to spread to the broader bond market.


  • Report this Comment On December 02, 2010, at 2:17 PM, whitepapers wrote:

    Bubbles. I've been trying to identify the next bubble. Good luck right? Here are some that I've recently heard and thought about. Bond Market, Gold, and college debt bubble.

    Bond market

    Written about in the article above.

    Gold -

    Buffett on 10/19/10 ; "You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?"

    College debt bubble -

    "As a result of easy credit, declining grants and soaring tuitions, more than two-thirds of students graduated with debt in 2008 — up from 45 percent in 1993. The average amount is $24,000, according to the Project on Student Debt."

  • Report this Comment On January 12, 2011, at 5:56 AM, whitepapers wrote:

    I wanted to add a couple I've been thinking about lately: weddings and bond markets. Actually weddings did fall from 2007-2009 from $28k to $19k, but this year the average cost went back up to $24k.

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