A $250 Billion Blunder?

"The art of being wise is the art of knowing what to overlook,'' American philosopher William James said.

Conrad Gann, the president of West Coast liquidity tracker TrimTabs Investment Research, figures investors ought to heed those words about knowing what to overlook -- especially so when it comes to their seemingly desperate craving for corporate bond funds in a quest for fatter returns than the paltry payouts they receive from money-market mutual funds.

It's a significant financial issue since many investors are in a quandary. While many are being sorely tempted by a revitalized stock market -- up nearly 60% from its March lows (as measured by the S&P 500) -- many others, stung by vicious losses in their equity holdings, are far more concerned about preservation of assets and generating juicier returns without taking on sizeable risk.

Corporate bond funds, far less volatile than stocks and up this year 11.7%, would seem to fit the bill for the more conservative-oriented investor.

The numbers dramatically illustrate the investor's love affair with corporate bond funds. This year, for example, they have snapped up an estimated $250 billion of such funds, more than 20 fold the $9.2 billion they've poured into equity funds. Much of this cash infusion into corporate bond funds is coming from money being yanked out of those puny-yielding money-market funds.

The problem here is love affairs die fast on Wall Street and Gann figures investors this one could wind up on the rocks. He feels investors are playing with fire in making such a switch, noting they're ignoring the threat of a significant risk -- a swing to higher interest rates, which could send net asset values of corporate bond funds plunging.

In other words, this year's $250 billion of investments in such funds, of which an estimated $26.4 billion has come so far this month, could be a blunder of major proportions, Gann suggests.

Typically, he notes, with a bull market in equities, you would expect investors to channel money into equity funds, not corporate bond funds. The fact they're acting in a contrary fashion is a message that many of them are still running scared, he says.

Laurence Ames, a strategist at Los Angeles-based MCR Associates agrees. Numerous economists expect Ben Bernanke & Co. to keep interest rates low and avoid any new hikes, given the shakiness of the economy. Ames disagrees, arguing that the present deflationary environment is bound to take on inflationary tones in wake of the heavy money printing to beef up the economy. "Inflation," he says, "is not a question of if, but when, and the fear of a new inflationary spiral is one of the reasons we've seen the recent spurt in the price of gold to above $1,000 an ounce," he points out.

The precarious position of the greenback, coupled with the need to fortify it, is viewed as yet another catalyst that could prompt the Federal Reserve to push interest rates higher, placing corporate bond funds in jeopardy. Another reason is to stem any substantial sale of dollars by Asian countries and an unwillingness to buy more. China, for example, holds more than $800 billion worth of U.S. Treasuries and it's thought unlikely that it will buy any more, in turn putting upward pressure on rates.

To Ames, "there's a real danger bonds could be ticking time bombs."

Money manager Joan Lappin of Gramercy Capital Management also hoists warning flags that corporate bond funds may not be as bullet proof as investors think. "We know," she says, "that the escalating U.S. budget deficit will require the U.S. Treasury to issue to issue more and more Treasury bonds in the weeks and months ahead. To lure future buyers, rates will have to rise." Accordingly, she observes, "bonds just don't seem to be a logical investment at this time."

John Wayne once said "courage is being scared to death and saddling up anyway." When it comes to corporate bond funds, investors are clearly not scared to death. But if rising interest rates are indeed on the horizon, many conservative investors could become scared pretty quickly and they'll regret ever saddling up.

The bottom line here: If you're a bondholder, keep close tabs on the interest rate chatter. There could come a point when it's time to get out of the saddle.

Write to Dan Dorfman at [e-mail].

 

 

Comments

[WilliePilgrim]

why not just start printing money on soft absorbent paper and make it available on rolls?

[Aaror]

The really interesting/scary question is, what sort of feedback loops would be involved in bond yeild increases?
Say the treasury increases average yeild on T-bills .25%, and the Fed increases interest rates the same (paltry) amount. it would cut about 1% off the value of a 5 year bond, and 3.5% off a 30 year bond. If you are investing for security, you could get spooked by a sudden loss, and might move money out of that fund. This would make future capital more expensive, which would lead to more rate hikes, which would lead to more bond losses.
Eventually the worldwide bond market would notice, and this would decrease the value of the dollar, which would encourage foreign bondholders to sell US dollar bonds for other currency bonds, which would decrease demand for US bonds and increase the yeild required, which would make existing bonds worth less...
Repeat this enough times and you see how 1930's Germany felt...