Bonds: Avoid the next great bubble

“Fueled by a combination of fear and greed. ” That is how CNNMoney.com describes the bond market bubble. According to CNNMoney.com:

A projected $380 billion will pour into bond funds this year, more than went into domestic stock funds in the past decade. That's on top of a record $376 billion last year. All this money flowing in has made bonds very expensive.

It's true that bonds are less volatile than stocks. But in fact they lose money just as often as equities do. "I don't think the public understands they can lose money in bond funds," says James Swanson, chief investment strategist at MFS, an asset-management firm in Boston.

So that's the fear part. The greed part comes from an entirely different group of people: safety-loving folks who normally park their money in cash, such as bank savings accounts, CDs, or money-market funds. Fed up with the meager interest rates those accounts are paying these days -- the average taxable money-market fund yields 0.03% -- they're venturing into short-term bond funds to eke out a bit more yield.

Why the bubble could burst

One part of the bubble is already leaking air: long-term government bond funds. Because they invest in super-safe U.S. Treasuries and other forms of government-backed debt, they were a popular place to hide during the mortgage meltdown.

But when the economy began improving and rates on 10-year Treasuries began rising (from about 2% at the end of 2008 to as high as 4% in April before slipping to 3.3% today), these funds started suffering. In fact, the Vanguard long-term Treasury bond fund fell 12% in 2009 and, despite the recent run up in Treasury securities, is still down 5% since the end of 2008.

Experts say that's just the beginning. Read about the major factors that could harm bonds further here.

Treasuries Set for Worst Year Since 1978 as U.S. Steps Up Sales

From BusinessWeek.com:

Treasuries headed for the worst year since at least 1978 as the U.S. stepped up debt sales to help spur growth in an economy recovering from its deepest recession in six decades.

U.S. seven-year notes were little changed before today’s $32 billion sale of the securities, the last of three auctions this week totaling $118 billion. The Treasury sold a record- tying $42 billion of five-year securities yesterday and $44 billion in two-year notes on Dec. 28. U.S. government securities have fallen 3.6 percent this year, according to Bank of America Merrill Lynch indexes, the worst annual performance since at least 1978, when Merrill began collecting the data.

“It’s the last hoop the market has to jump through in 2009,” said James Collins, an interest-rate strategist in the futures group in Chicago at Citigroup Inc., one of 18 primary dealers obliged to participate in the Treasury’s auctions. “Yields have been trending higher. It’s been a response to increased supply.”

The yield on the benchmark 10-year note was little changed at 3.80 percent at 9:24 a.m. in New York, according to BGCantor Market Data. The yield has increased 1.58 percentage points this year. The 3.375 percent debt due in November 2019 fell 1/32, or 31 cents per $1,000 face amount, to 96 17/32. The yield on a seven-year note was little changed at 3.31 percent.