After the Fed's Statement, Are You Crazy to Own Bonds?

Last Updated Apr 27, 2011 1:28 PM EDT

[updated Apri 27]

Every once in a while, you get to see a market train wreck coming. It should have been obvious in 2006, for example, that real estate was about to be slaughtered, or in 2000 that tech stocks had it coming. Determined not to be fooled again, a lot of smart people are calling for a comparable Armageddon in bonds. Newsletter writer and bond manager Marilyn Cohen calls it "bondland's nuclear winter," which gets my vote for best alarmist rhetoric.

You have to admit, the case against bonds is pretty strong:

  • Today the Federal Reserve said it would continue to hold short-term interest rates near zero percent "for an extended period," a policy that has no doubt contributed to the decline in dollar and inflation in commodity prices. A lot of economists, including some on the Fed itself, believe the policy can't help but spread inflation like a grassfire, which would badly singe bond prices.
  • The Federal Reserve purchases 70% of all Treasuries. Today the Fed Open Market Committee affirmed that it would stop buying on June 30, as planned, although it will continue to spend just enough to replace maturing bonds in its portfolio. What happens to an asset's price its biggest buyer steps away? It falls, doesn't it?
  • As if that weren't enough, last week Standard & Poor's lowered the credit outlook for Treasury bonds, the benchmark for every dollar-denominated bond now traded. There's now a one in three chance that Treasuries will lose their AAA-rated status.
  • Both Bill Gross of PIMCO and Dan Fuss of Loomis Sayles, two of the smartest bond managers around, have stopped buying Treasuries. Let's repeat this: Two of the most successful bond managers of their generation are uncomfortable owning the largest sector in their category.
That's worrisome, to put it mildly. Talking about bonds may be about as exciting as talking about 18th century land-use policy, but if you have been following most adviser's directions, you have 40% of your life savings in bonds. That's a lot, for an asset class supposedly headed for nuclear winter.

I have nothing to offer against the bearish argument except to point out that the worst market crashes are rarely the ones everyone sees coming. For every wicked-smart person selling bonds, someone else is buying. Some of those buyers are wicked-smart, too. They include Rick Rieder, chief investment officer of Blackrock, the world's largest mutual fund company, and Jeffrey Gundlach, who has a knockout track record at DoubleLine Capital. As they see it, the end of the Fed's buying could help slow the economy. Bad for stocks, but actually good for bonds. Gundlach points out that the last time the Fed stopped buying, bond prices actually rose.

There's not much to be gained guessing whether Gundlach and Rieder are smarter than Gross and Fuss. A prudent portfolio should balance both. The widespread unease about bonds either means that this is one of those train wrecks everyone sees coming, or that investors are suffering from what behavioral economists call "availability bias" and what layman call "I got killed in real estate in 2008 and I won't let it happen to me again in bonds." You don't know.

What to do? Be alert to the risks in bonds-even make an adjustment at the edges by moving some money into cash, stocks, or even gold-but stick to your plan generally. It's called diversification. It means accepting that whatever happens in the bond (or any other market) your portfolio will never be 100% right. But it also means you're protected against outcomes that seem 100% certain and then never come to pass.

More on MoneyWatch:

What the Fed said: Today vs. Last Month
5 Questions We'd Like to Ask Bernanke
The Fed and Inflation Expectations