The Bond 'Bubble': Are Small Investors Taking Too Big a Bet

The Bond 'Bubble': Are Small Investors Taking Too Big a Bet?

By JASON ZWEIG

That has been a constant refrain on Wall Street lately, as retail investors poured over $375 billion into bond mutual funds last year and another $230 billion thus far in 2010—even as interest rates have shriveled toward zero and the risk of future losses has risen. Households also have yanked roughly $70 billion out of U.S. equity funds this year, though the stock market has gained 4%.

So, as usual, the lemmings have rushed in just the wrong direction—or so runs the official narrative among professional investors, who fancy themselves to be immune from such behavior.

.Retail investors certainly don't have a good track record when it comes to buying bond funds en masse. They pumped tens of billions of dollars into them in early 1987, right before rates shot up and bonds got pounded; the same thing happened in 1994.

But this time around, retail investors have had no choice if they wanted to earn income.

On Sept. 10, 2008, before the collapse of Lehman Brothers, the Federal Reserve held $480 billion in U.S. Treasury securities. By the end of 2009, the Fed held $1.84 trillion—including $1.2 trillion in mortgage-related securities that the central bank bought up to keep the financial system from imploding.

Since spring, the Fed has essentially stopped buying, but it still holds $2.04 trillion in bonds, up $1.5 trillion from the end of 2008. This massive buying, nearly triple the amount that retail investors added to bond funds over the same period, has helped drive interest rates to near-record lows.

Meanwhile, foreign investors have bought $373 billion of Treasury debt so far this year, or nearly 60% more than U.S. households have put into all bond funds combined.

If anybody is to blame for a bond bubble, it isn't Joe Schmo; it's Uncle Sam, with some help from overseas.

"The Fed has effectively been taxing money-market funds [by cutting short-term interest rates] to recapitalize the financial system and to make things easier on borrowers," says Dan Dektar, chief investment officer at Smith Breeden Associates.

The rush into bond funds, as big as it has been, still leaves many households with surprisingly little exposure to the risk of losses if interest rates rise. According to the Investment Company Institute, 20% of all mutual-fund assets were in bond funds as of the end of last year; as of the end of August, that had risen to 24%.

Furthermore, retail investors haven't been bingeing on long-term bonds, which stand to lose the most if interest rates rise. According to Kevin McDevitt, an analyst at Morningstar Inc., of the $168 billion that retail investors have added to taxable-bond funds so far this year, a grand total of $1 billion went into long-term funds. Short-term funds took in $33 billion; intermediate funds, $59 billion. "Even though long-term Treasurys have had great performance," Mr. McDevitt says, "investors haven't really been chasing those returns."

What they have been doing is responding rationally by moving out of money-market funds. Nearly $500 billion has come out of money funds so far in 2010. Thus, it seems, most people aren't selling off their stock funds to buy long-term bond funds. They are getting out of money markets and inching into short-term and intermediate bond funds.

"When yields are really low and you're not getting paid to take risk, you shouldn't take risk," says Kenneth Volpert, head of taxable bonds at Vanguard Group. With long-term Treasurys yielding about 3.5%, but standing to fall in price by at least 10% if interest rates rise rose just one percentage point, most retail investors seem to know enough to concentrate their new bond money in shorter-maturity funds.

Investors do need to keep some warnings in mind, however. The U.S. government stepped in during the financial crisis to protect money-market funds against any losses. "You're just never going to see that in short-term bond funds," Mr. McDevitt warns.

A typical short-term fund stands to lose about 3% if interest rates rise one percentage point. If you have cash that you must keep safe, keep it in a high-yield savings account or a certificate of deposit, not a short-term bond fund. Or buy short-term bonds outright and hold them to maturity.

While few people may be reaching for yield in U.S. bond funds, $10.3 billion has flowed into emerging-market bond funds so far this year—greater than a quarter of the total inflows into short-term U.S. bond funds. Taking a bit more risk with a bit of your bond money is fine. But taking a lot more risk with a lot of it isn't.

— intelligentinvestor@wsj.com; twitter.com/jasonzweigwsj