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Bill Freehling is a business writer for The Free Lance-Star and Fredericksburg.com. This blog is on Fredericksburg-area business. Send an e-mail to Bill Freehling.

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This week’s (8/22) investing column

JUST ABOUT every day over the past few weeks, The Wall Street Journal has run an article or two about risk-averse investors pouring into bonds and bond funds.

Investors are fleeing stocks for the perceived safety of bonds, which is driving bond prices up and yields down. U.S. Treasury 10-year notes are now yielding just 2.6 percent, and shorter-term bonds yield even less.

It’s not just government bonds that investors are craving, either. Companies seen as speculative are issuing debt in record numbers due to the strength of the high-yield, or junk, bond market. Investment-grade companies are rushing to borrow money at historically low interest rates.

Last week Johnson & Johnson, a pillar of financial strength despite recent problems with recalls, raised more than $1 billion by selling 10-year bonds with an interest rate of 2.95 percent, a record low.

That news suggests to many people, including myself, that the bond market is getting a bit bubbly. Johnson & Johnson, which has a long history of increasing dividends and plenty of earnings to sustain the payment, has a common stock that yields 3.7 percent. Why would people rush to buy the company’s bonds instead when they yield a percentage point less and offer little prospect of capital appreciation?

Warren Buffett is not in that camp. Buffett’s Berkshire Hathaway revealed this past week that it had spent about $1 billion on J&J stock during the second quarter. Other media reports have suggested that Buffett has been shifting around his firm’s bond portfolio so it has a shorter maturity.

Bonds with longer maturities fall more in price when interest rates rise. With the Federal Reserve now keeping rates at about zero, there is nowhere to go but up for interest rates once the economy recovers. When that occurs, bond prices will fall, and should inflation kick in as many expect bonds will get hit even worse.

In an op-ed in Wednesday’s edition of The Wall Street Journal, Jeremy Siegel and Jeremy Schwartz wrote that the bond market, particularly in U.S. Treasury bonds, has become a bubble akin to the technology-stock bubble of the late 1990s. They argue that investors are too pessimistic about economic growth prospects.

“Those who are now crowding into bonds and bond funds are courting disaster,” they write.

As Siegel and Schwartz point out, there are numerous companies on strong footing who pay dividends that exceed the rates of U.S. Treasury notes and have the ability to raise payouts as earnings improve.

None of this is to say that bonds shouldn’t play some role in every investor’s portfolio. They tend to zig when stocks zag, which smoothes out total returns.

But it’s rare that an asset that receives seemingly irrational attention from investors is the one that performs the best in future years. Bonds today carry textbook signs of being in a bubble, and investors should think carefully before committing new funds to them.

Permalink: http://news.fredericksburg.com/businessbrowser/2010/08/22/this-weeks-822-investing-column/

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  • LarryG

    not all bonds are risky. Municipal Bonds with AA and better ratings are …at least SAFER than the ones you cite in the article.

    Are people so stupid as to not understand the difference?

    The reason people are out of the stock market is pretty simple. They do not trust Wall Street nor the folks who supposedly give good advice about investments.

    The trust and confidence of the ordinary main street investor has been seriously undermined by Wall Street skulduggery and just like the depression – people have long memories so I’m not convinced that the small investor is going to come back to the stocks.

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  • bhaas

    I am curious about the effect this “bubble” might have on municipal bonds such as the ones localities issue for infrastructure? Are they “bubble” proof?

  • Bill Freehling

    Larry — It depends what your definition of safe is. Nobody is arguing that these bonds are going to default. J&J will make the 3 percent payment as will other highly rated corporates and government bonds. But that doesn’t mean that the investment can’t decline in value, or that the investor is necessarily going to get out in principal what he/she put in (if the bond is bought at a premium to maturity). If it’s me I’d rather take the higher dividend yield on the stock, which can increase in value and whose stock price and dividends will rise if the company fares well. You have no such opportunity in bonds.

    Bill — The current state of the bond market is great for issuers. They get to issue debt at really low interest rates, meaning their cost of funds is lower than it might have otherwise been. It’s the investors that aren’t getting such a great deal at today’s rates.

  • bhaas

    I presume that without, or with poor, investing those low interest rates are a “moot” point, eh?

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