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Mutual Funds

Analyst unworried by bond bubble

By Mark Jewell
Associated Press / July 4, 2010

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Listen to top investment strategists, and you’d think it’s almost certain that investors have set themselves up for a fall by flocking into bonds.

Although traditionally considered a safe haven, bonds aren’t without risk. Yet any fixed-income fizzle won’t be as painful as the late 2008 crash for stocks, the thinking goes.

The reality is that bond prices will eventually decline because current near-zero interest rates have nowhere to go but up. When the Federal Reserve eventually raises rates, prices for existing bonds with locked-in rates will drop. That’s because investors will be able to buy newly issued bonds paying higher interest. For example, for each single-percentage-point increase in rates, expect the price of a bond maturing in five years to suffer a roughly 5 percent decline.

The price decline could more than offset the typically modest interest income from the bonds, hurting investors in bonds and bond mutual funds alike.

It could shock safety-minded Americans who have sought refuge from volatility by shifting out of stocks and pouring about half a trillion dollars into bonds over the past year and a half. It’s this steady inflow that has several money managers, including bond fund managers, sounding the alarm for fixed-income. After all, higher inflation and interest rates could quickly erode retirement savings for investors who might fail to resume taking an appropriate level of risk.

Yet there are reassuring words from Curtis Arledge, a chief investment officer for BlackRock Inc., who guides strategy for the New York-based company’s $589 billion in actively-managed fixed-income assets.

Arledge’s take on the biggest current risk to bonds: “I’m not trying to be the great bond bull here, but I think people are just too worried about rates.’’

He acknowledges higher rates will eventually trim already tiny yields.

But investors willing to take on more risk are finding more buying opportunities. The spread between Treasury yields and those for higher-yielding corporate junk bonds has lately topped 7 percentage points, the biggest spread in more than six months. Safer investment-grade corporate debt has been yielding about 2 percentage points more than comparable Treasurys.

Those heftier yields for riskier fare come after corporate bonds offered stock-like returns last year, rebounding from negative territory in late 2008. The 2009 results capped a decade when bonds uncharacteristically outperformed stocks.

But even with the recent surge of cash into bonds, Arledge isn’t worried about a bubble. His key points:

Investors seeking safety, not returns: Investment bubbles typically build as money pours into the riskiest areas within an asset. Think of investors who rushed into stocks of fast-growing Internet companies in the late 1990s, and avoided steadier dividend-paying stocks as well as bonds. The tech stocks eventually tanked.

Arledge argues the risk of a bond bubble is low because the bulk of the flow into fixed-income recently has gone into safe, low-yielding fare such as Treasurys, rather than into junk bonds — fixed-income’s equivalent to the most volatile types of stocks.

Rate-raising pressure remains low: The Federal Reserve has held rates near zero since December 2008. But with the economy still slow, policy makers are in no rush to head off the risk that low rates will eventually fuel inflation. The Fed pledged again last month to maintain record-low rates for an “extended period.’’

Many expect rates to rise by next spring, but not Arledge. He figures that probably won’t happen until at least late next year.

Borrowing is down: If the overall level of borrowing in the economy were high, it would pressure the Fed to raise rates to prevent a surge in corporate and consumer debt like the one that helped fuel the financial meltdown. But that’s not happening, despite the government borrowing binge that’s drawing so much attention now.

Arledge argues many have forgotten that the rise in government debt continues to be offset by reduced private borrowing by corporations and individuals taking out consumer loans.

Where to find yield: Arledge predicts 10-year Treasury yields will remain low at 3 to 3.5 percent over the next three to six months. He figures investors who have embraced government bonds may eventually tire of low yields and venture into higher-returning corporates.

He advises investors look to bond managers with wide leeway to buy bonds of varying durations and credit quality.

Investors who have sought refuge by loading up on safer short-term debt, he says, “will start to say, ‘I need more yield, if we’re going to be in this environment for a long time.’ ’’