No Bond Bubble—But No Bargain, Either

10/12/2010 1:30 pm EST

Focus: BONDS

Janet Brown

Editor, NoLoad Fund*X

Janet Brown, editor of NoLoad Fund*X, says investors are flocking to bonds for many reasons, which could forestall a bubble bursting, but she says stocks offer superior returns over time.

Despite September’s reputation as the worst month of the year, stock markets enjoyed their best September in 71 years.

The Dow Jones Industrial Average gained a solid 8%, [and] the Standard & Poor’s 500 Index [rose] 9%, while the small-cap Russell 2000 rallied 12% and the technology-oriented Nasdaq Composite surged 13%—more in one month than most investors gained all year.

Unfortunately, many fund investors did not participate in the surge as [they] continued to flee stocks for the perceived safety of bonds and gold.

The most extreme stock market drop of our lifetimes, ending in early 2009, left many investors risk averse. Since the start of 2009, the total net new investments in bond funds are now $620 billion. Meanwhile, investors have withdrawn $100 billion [from US equity funds] since the beginning of 2009.

There’s no denying we have come through a decades-long rise in the value of bonds:. Starting in the early 1980s, bond prices rose and investors enjoyed a golden era we will likely not see again.

[Now,] yields are at historically low levels, and some investors wonder if a “bubble” is forming.

That’s not necessarily what we are seeing at this time. There are many factors influencing the cash flows into bonds and bond funds. Some are demographic: As baby boomers age, they seek income and stability rather than growth. That does not imply a bubble, but a shift in investor preference. This trend could last a while (perhaps years), as more and more boomers approach retirement, and that could help cushion the impact of a bond bubble should one develop.

Another factor is fear. Investors are turning to bonds due to increased stock market and economic volatility. Additionally, we are seeing actual purchases of fixed-income securities by the Federal Reserve.

The feeble economy has some observers concerned about deflation–at the very least, we may see low inflation and low yields leading bond prices to go sideways for quite some time. This has certainly happened in the past.

The trailing-ten-year return for US equities is worse than it’s ever been. Yet, looking back over the longer term, stocks have provided the best returns compared with bonds or cash. Comparing all the previous rolling 20-year periods to date, the average return from stocks equals the best return that bonds ever produced in any 20-year period.

Further, history shows that stock investors typically earn higher-than-average investment returns after periods of sharp losses. After previous periods of low stock returns, the subsequent ten-year annualized total returns were above average. Investors who focus on the short term often underperform by attempting to avoid near-term losses.

Bonds, for all their ability to buffer portfolio losses, have not offered much protection against eroding purchasing power in the long term; for that, you need stocks. But the price we pay for higher long-term returns is market volatility.

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