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Busting bonds' bubble

At the end of the dot-com stock boom in late 1999 and early 2000, it was harder and harder to find someone to say that buying into that mania was a mistake.

There were plenty of Wall Street veterans who saw a catastrophe in the making. But many increasingly felt like idiots voicing that opinion publicly because they had been so wrong for so long.

The technology-dominated Nasdaq composite stock index had soared an average of 40 percent a year from 1995 through 1999. The tech bull market looked like it might go on forever.

But they never do. That one ended in disaster with the crash of 2000-02.

A decade later, the buying binge of the moment is in the bond market. Two investments could hardly be more dissimilar than dot-com stocks and boring bonds. But now, as then, raw emotion is driving investors.

Also now, as then, the magnitude of the buying makes it a difficult force to oppose. It's always more comfortable to close your eyes and go with the flow.

The emotion driving the bond market's continuing rally is the flip side of what drove the tech mania. Jumping on the runaway dot-com train in 1999 was all about unbridled greed. For bond investors, the motivation is fear — that is, fear of losing.

After two devastating stock bear markets in one decade, many Americans no longer have any stomach for equities. Real estate also has been a bust. And cash accounts pay nothing.

The bond market was a refuge waiting to be discovered, or rediscovered. In early 2009, as the economy crashed, individual investors began to aggressively buy government, corporate and municipal bonds. They haven't stopped.

Net cash inflows to bond mutual funds reached $156 billion in the first half of this year, on top of the record $375 billion that flooded into the funds in all of 2009, industry data show.

By contrast, stock mutual funds in total have taken in a paltry net $9 billion in new money this year.

The world's biggest bond fund, the $234 billion Pimco Total Return fund, by itself is taking in about $1 billion in fresh cash every week.

There's a herd mentality about bonds, but usually the herd is chasing hot returns, as it was in the tech sector a decade ago. But bond buyers have no illusions about reaping massive returns on fixed-income securities. Their expectations are downright pedestrian.

Many investors are simply afraid that even the current mid- to low-single-digit annual interest rates on bonds could shrink further if they wait to buy, should the economy worsen and the Federal Reserve makes another major push to drive rates down across the board.

Of course, investors themselves are driving down interest rates as they shovel cash into the bond market. Buyers essentially wind up in a bidding war for the securities, which in turn allows the issuers of the debt — Uncle Sam, municipalities and companies — to drop the rates they pay to borrow.

Joe Lee, a municipal bond trader at De La Rosa & Co. in Los Angeles, says many investors' justification for buying today is that it's better than earning zero.

"No one likes these yields," he said. "But people have been sitting on cash, and they feel like they have no other choice."

That is the kind of chatter overheard in bubble markets: I really don't want to do this, but I will anyway.

What's happening in the bond market surely has the look and feel of a bubble: The market is moving fast, and it's pulling in huge numbers of investors.

But bubbles, as we've seen over and over, can persist for extraordinarily long periods before busting.

There are three possible scenarios for the bond market from this point.

• One is that interest rates fall even further, almost certainly because the economy crumbles. If that's what you expect, locking up money in high-quality bonds at current yields is a logical move.

That scenario was bolstered recently by the government's report that the economy grew at a disappointing real annualized rate of 2.4 percent in the second quarter.

• A second scenario is that the economy muddles along and interest rates just hold near current levels indefinitely. You'd collect interest on your bonds, which may not be much but still would beat cash accounts at zero.

• The third scenario is the potential nightmare: Market interest rates rebound sharply, because the economy is stronger than expected or inflation surges, or for some other reason we can't now conceive.

If market rates rise, older bonds issued at lower fixed rates would fall in value. The longer a bond's term, or maturity, the more it would lose on paper.

Bubble or no, the lower interest rates go, there is an overwhelming advantage in bonds for the borrowers, at the investor's expense. You're earning less and less to compensate for whatever might go wrong.

At these interest rates, "There's very little room for error," said Richard Ciccarone, research chief at McDonnell Investment Management in Oak Brook, Ill.

Busting bonds' bubble 08/07/10 [Last modified: Friday, August 6, 2010 8:48pm]

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