Has the Bond Fund Bubble Burst? Concerns of an Individual Investor

For the past month I have seen the value of my bond funds steadily decrease. I have been worried about these investments for awhile now. Apparently I'm not the only one concerned. In the past few days I've been reading articles from experts that are voicing the same concerns.

As an investor who is retired, I have counted on interest from my bond funds to help supplement my part time income. The economy has been playing some cruel jokes on people in the past few years. Just when you think you have saved enough for retirement the money just seems to disappear. It vanishes into thin air.

I decided that, for me, the chances of loss are just too great. Today I took the majority of my money invested in bond funds and moved it into a money market fund that doesn't pay much in dividends. Like many 401 Ks and retirement plans, choices are very limited on where to put cash. I'd rather do that, though, than lose money. I'll just sit on the sidelines, and wait to see what happens.

Here's the deal with investing. If you're going to save your money as an individual and invest it, you also need to manage it. With investing, you can't just make a decision and sit back and forget about it. As in Life, investing is about change. You may not like it, but you have to be flexible enough to change.

Why did I make this decision? First of all the decline in the assets in the last few months has been consistent.. Remember, I'm just an individual investor not an expert. I have been managing my own assets for about twenty-five years. If you're going to manage your own portfolio, you need to stay informed. The financial woes of our economy caught me pretty much off guard at the beginning of the recession. The hardest thing not to do when something like this happens is panic. That experience made me nervous and wary about my investment decisions.

I didn't pull all my investments out, but over time I sold off stocks that were doing poorly and readjusted my portfolio. Thankfully, I didn't lose money. I know others that rushed to sell all of their investments that were losing money, and took heavy losses.

In the past few days I have seen several articles that showed concern over the bond market. On December 13, 2010 John Hollyer of Vanguard did a podcast and below is the transcript of Mr. Hollyer's interview:

If you prefer to listen to the podcast, you can do so here.

" Cash flows

Interviewer: Hello, and welcome to Vanguard's Investment Commentary podcast, our monthly perspective on events and trends affecting the economy, the financial markets, and investment management. I'm Casey Aspin. In this month's episode, which we're taping on November 24, 2010, we're going to discuss market and environmental risks facing fixed income investors. I'm here with John Hollyer, who heads Vanguard's Risk Management and Strategy Analysis team. Welcome, John.

John Hollyer: Hi, Casey, good to be here.

Interviewer: John, let's start with bond cash flows, which have been extraordinary since the market top in 2007. Over the 3 years ended September 30, 2010, investors have poured $710 billion into bond funds while withdrawing $162 billion from money market funds and investing only $50 billion into stock funds, and that data comes from Strategic Insight Simfund. John, are investors making a massive bet on bonds?

John Hollyer: Those figures that you just shared with us, Casey, are certainly indicative of major changes in people's portfolios. And I think they're understandable given the history of the last 3 or 4 years. We've seen periods of great volatility and major negative return in stock markets. We generally have seen attractive and positive bond market returns of maybe 6% to 8%. And we've seen money market interest rates go effectively to zero. So, all those forces have been acting on people either to readjust their allocations to their portfolio or to seek return where they feel they'll get most of it.

Low yields pose risk

Interviewer: So, there's an aspect of performance chasing, but isn't there also an aspect of reducing volatility by going into bonds, and for those investors, could there be some surprises ahead?

John Hollyer: We're definitely concerned about that, Casey. As I mentioned, trailing 3- to 5-year bond returns have been 6% to 8%. The thing that concerns us is that those attractive returns have been primarily driven by declining yields, and, in the long run, yield is the primary return of a bond investment. Yields today, if we look at the Barclays Aggregate Index, are in the 2% to 3% range.

We're concerned that if rates were to rise, even relatively small amounts, there's very little income cushion to help offset price declines, and investors could easily see in the next year, 2 or 3 years, periods of negative bond market returns.

Industry consolidation

Interviewer: Are there other risks that may not be as obvious to fixed income investors?

John Hollyer: We're very concerned about the level of liquidity in the bond market. We've seen in the past few years major banks or bond dealers close or be merged into other firms. The firms that are there are being increasingly careful about how they risk manage their capital allocation to market making. We're concerned that, if there were a material shift in the flows of bonds towards selling and investors allocating assets away from bonds, that the ability of the market makers, Wall Street primarily, to absorb a large amount of bond selling is limited, and we could see larger transactions' costs, which are essentially a drag on fund performance, and we could see greater bond market dislocations or volatility associated with periods of selling.

That's a real concern to us. We're structuring our portfolios with that in mind, and we have for a long time. We keep core portions of our portfolios in highly liquid securities. We monitor carefully the cash flows in and out of our funds, and we'll adjust those liquidity levels according to our outlook for how investors might behave and how the market making capacity of Wall Street will accommodate our needs.

Unprecedented actions

Interviewer: So, looking at the role that governments and central banks are playing, around the globe we've seen fairly aggressive actions to shore up banks and provide stimulus. Is that a cause for optimism?

John Hollyer: I think it is. It is a policy response that's been pretty robust, particularly in the U.S. on the part of the Federal Reserve. They've done over a trillion dollars of what's been referred to as quantitative easing: buying government securities to expand the Fed's balance sheet and the amount of money available in the economy. That was in 2009 primarily and they have just recently announced another round of $600 billion. So, I think it's a cause for optimism to see that the Fed is taking very proactive and significant steps to help provide the economy and to forestall the risk of a material deflation, which would really be a very difficult thing for our economy to absorb and would hit people hard.

There are concerns over things like inflation and other unintended consequences. This type of monetary policy action is pretty much unprecedented in scale, and we are concerned about unintended consequences and the future stages under which all this monetary easing will potentially have to be unwound should the economy regain its potential growth rate.

It does help me be optimistic that they'll be successful, but it's not without concern given its unprecedented nature.

Banking system reform

Interviewer: Much of the bailout packages and stimulus that we're discussing here originated with the problems in the financial system. Would you say that banks have stabilized to the point where they are less likely to cause problems in financial markets?

John Hollyer: First of all, there is a move towards higher capital requirements, which should bolster the banks' resilience in the face of market turmoil. Important to mention the government policy responses going on in Europe in the form of bailouts to countries-Greece and recently Ireland-as well as banks, and that also is relatively unprecedented. Not exactly clear where all this will lead as far as unintended consequences.

There are additional provisions in banking regulation coming out of the so-called Basel III Agreement, which is essentially led by the Bank for International Settlements and a global banking regulator in Switzerland. Importantly, they are putting forth a rule at this point that banks greatly increase the liquidity reserves they hold against any commitment they would have to pay out in 30 days. This really could lead to a wholesale restructuring of the short-term funding markets and the bond market generally. Again unintended consequences, but generally it's going to raise the price of liquidity to issuers of things like commercial paper and for issuers of municipal money market variable rate demand notes.

An additional requirement coming out of this Basel Accord has to do with the funding ratio. They generally would have structured the regulation to encourage banks to more closely match the time-to-maturity of their funding or borrowings with their assets, which are primarily loans. Again, designed to make banks more stable through potential market crisis, which is a good idea, but we're talking about major portions of banks' funding requirements and lending and unintended consequences are going to abound.

Allocation decisions

Interviewer: John, given the unprecedented actions taken by the Federal Reserve Board and the European Central Bank, as well as unintended consequences coming from banking regulations, are there ramifications for investors who are looking at their asset allocation in the wake of a $710 billion flow of funds into bond funds?

John Hollyer: I think it's time for investors to go back to basics and think long and hard about their asset allocation and really determine whether they're willing to stick with it in the event that returns or market movements are somewhat unexpected. I think they should be very realistic about the expected return that they'll get from bond funds going forward and probably ratchet down somewhat their expectations if the past is their primary reference point.

And, finally, probably avoid major shifts in asset allocation. We don't know exactly what all these major global policy and economic forces are going to produce. There could be periods of uncertainty and dislocation, and an asset allocation that's gone from one extreme to another could really be problematic in that kind of environment.

Interviewer: Well, that's a good place to stop, John. Thank you for your time.

John Hollyer: My pleasure. Thank you, Casey.

Interviewer: We hope you enjoyed this Vanguard Investment Commentary podcast. Be sure to check back with us each month for more insights into the markets and investing. Thank you for listening.

Notes: All investments are subject to risk. Investments in bonds are subject to interest rate, credit, and inflation risk. While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates.

Foreign investing involves additional risks including currency fluctuations and political uncertainty.

Past performance is no guarantee of future results.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund."

On December 10, 2010 an article was posted on Smart Money entitled, " Is the Bond Bubble Bursting? " from the Wall Street Journal. I also saw one of my bond funds drop by .60 per share in one day which is highly unusual. After listening to the Vanguard information and reading the Wall Street Journal article, I made the decision to move money.

I guess we'll see if I made a wise decision or not. One thing my husband always tells me when I'm making a trade, "Did you make money? If you made money, than don't worry about it." I made some money. Not a lot of money, but at least I'll be able to sleep tonight. At some point I'll make the decision to reinvest, but these are tough times that require caution. Especially if you're retired.

Sources:

http://www.smartmoney.com/investing/bonds/is-the-bond-bubble-bursting/

https://personal.vanguard.com/us/insights/audio/IC-risk-management-12132010