Bond bubble or not, bonds are getting risky
Investors who rushed into bonds to avoid risk may find precisely the opposite. Some call it a bond bubble.
Safety seekers, beware! That big bond portfolio may be riskier than you think.Skip to next paragraph
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A return of volatility has sent some stock investors running to the bond market. Others, tired of earning close to zero in bank accounts, are moving cash into bonds. For five of the first six months of 2010, investors have held 20 percent or more of their portfolios in bonds, says the American Association of Individual Investors. The average is 15 percent.
"I'm getting more money [from clients] than I know what to do with," says William Larkin, fixed-income portfolio manager for Cabot Money Management in Salem, Mass. "They have all this money parked in banks, all their operating capital, and it's moving to me because they're not interested in losing money" as inflation rates exceed interest rates.
But bond investors need to tiptoe through a minefield of risks that people wouldn't normally associate with an investment haven like bonds. Some economists are now calling the influx of money a bond bubble, perhaps as treacherous as the dot-com bubble a decade ago. The trick, investment professionals say, is to manage that risk by investing for the short term, looking beyond what are often considered the safest bond instruments, and not putting all one's eggs in a bond basket.
The obvious risk is a hike in interest rates. Hovering near 50-year lows since 2008, they'll have to rise sometime – some say within the coming year – driving down bond prices. Then, not only will today's bond investor be holding low-yielding issues, those issues may be worth less than their original price.
Another risk is inflation. With 10-year US Treasury notes yielding around 3 percent at the end of July, a small rise in inflation could mean investors lose money in inflation-adjusted terms.
The biggest risk is that buying the safest bonds, such as Treasuries, may make it hard for people to grow their money at all. "The cost of safety today is brutal," Mr. Larkin says. "Very few investment objectives can be achieved with Treasuries, with the yields they're producing, or with [certificates of deposit] or money markets."
Bonds are still useful in smoothing out market volatility, investment advisers say. But investors will have to use counter-intuitive risk-reducing strategies.