No Longer a Safe Haven in Bonds

After three giddy years, it may be time to cut back

That rumble you've been hearing for more than a year is the sound of investors stampeding to join the bull market in bonds. In the past 12 months, they've put a record $160 billion net into bond mutual funds, according to Chicago-based Bianco Research. Spooked by big losses in stocks and microscopic yields in money-market funds, they succumbed to bonds' siren song of double-digit returns in two of the last three years.

Bond prices, which move in the opposite direction to yields, are at the highest levels in over a generation. Yields on 10-year Treasuries, at 3.1% on June 13, are the lowest in more than four decades. Indeed, today's giddy bond market feels like a rerun of the NASDAQ tech bubble, says Richard Hoey, chief investment strategist at money manager Dreyfus (MEL )

For investors, the logical course is to shun bonds. The chances they'll fall outweigh the odds that they'll rise. The yields they offer are peanuts -- often less than the 1.4% average dividend yields on stocks after tax. Plus, bonds are vulnerable to an upturn in the economy, the big federal deficit, and flight of foreigners from the dollar. "When these markets correct, they correct violently," warns James T. Swanson, bond strategist at MFS Investment Management.

He and others are telling clients to steer clear. Jack Malvey of Lehman Brothers (LEH ) says stocks are a better buy than bonds because "interest rates are likely to increase at some juncture over the next year, year-and-a-half."

Of course, bonds could still go higher. "Late in any bull market, it's very hard to call the inflection point," says Dreyfus' Hoey. Today's bond market may be like the NASDAQ in February, 2000, within weeks of crashing, or like the NASDAQ in November, 1999, with an additional 50% gain to come, he says.

Plus, bond bears have egg on their faces because until recently, they've been wrong. Swanson has advised against bonds for nearly a year even as they've beaten stocks. "But we're sticking to our guns," he says. Bears have looked better since the stock market turned up in March. For the year through June 13, the Lehman index of U.S. bonds returned 5.2%, vs. 13.3% for the Standard & Poor's 500-stock index.

Of course, prudent investors diversify and don't try to call market tops or bottoms. And every portfolio probably needs some bonds, perhaps 15% to 55%, depending on age and the need for income. Bonds hold value much better in bear markets than stocks do. In 1994, the worst year for bonds in the last 40, the Lehman index lost just 2.9%. By contrast, the S&P 500 lost 22.5% in 2002.

If you believe deflation is a risk, Treasuries, particularly zero-coupon bonds, offer the best protection. Although corporate bonds pay more than governments -- a percentage point on single-A issues -- companies could find it hard to earn enough to service their bonds in a deflationary period. If you think the economy will pick up strength, go further down the credit scales to pick up more yield. Swanson recommends B-rated junk bonds for the optimum blend of risk and reward. They yield about 8.7%, or six points more than Treasuries, but are best held in tax-deferred accounts.

The conventional wisdom about bonds needs to be tuned to the times. They're no longer automatic safe havens, so proceed with caution.

By David Henry

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