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December 11, 2012 11:04am NYSE:AGG NYSE:BND

Famed American journalist and essayist H.L. Mencken once said, “Democracy is the theory that the common people know what they want and deserve to get it good and hard.” I know a lot of conservative and libertarian types who are nodding their heads after seeing the results of last month’s national elections. But now I’m beginning to think that

American investors are no different.

A little more than a decade ago, we witnessed a terrific bubble in internet and technology stocks. When it popped, investors licked their wounds and shifted into high-flying real estate (which, as you may recall, “always goes up”), and another bubble formed. When the air rushed out of that, they took an even bigger hit. Now, chastened and wiser, they are now shifting to the safety and security of… bonds?

To quote Charlie Brown, “Good grief.”

According to the Investment Company Institute, bond funds are showing record weekly inflows. Just for the 12-day period ended November 20, bond funds took in more than $10 billion. This money did not come out of money market funds with their microscopic yields. (Money markets are taking in more than $8 billion a week, too.) The money came mostly out of stock funds, which continue to see huge net redemptions.

This is a curious development. After all, equities are cheap relative to earnings, while corporate profits and profit margins are at record levels.

Corporate, municipal and Treasury bond yields, on the other hand, are at record lows. That’s another way of saying bond prices are at record highs.

So why are investors plowing into them? For two reasons. Number one, we have seen a historic 30-year rally in bonds. Yields – which exceeded 16% in the inflationary early ‘80s – are now near record lows. This means that virtually all bond funds have fabulous 5-, 10- and even 30-year track records. What many investors don’t understand is it isn’t just unlikely this performance will continue. It’s mathematically impossible. Yields cannot go from 2% to negative 14%.

The second reason is that Bernanke is signaling he will keep short-term rates low right into 2014. A couple of caveats are in order, however. The first is this knowledge is fully discounted in bond prices already. The second, as Bernanke would happily concede, is that he is only signaling his intention. What the Fed actually does will depend on many factors, from commodity prices to economic growth to changes in the CPI.

I realize that bond yields may stay low for some time. But they will not stay low indefinitely. As Warren Buffett said at the last Berkshire shareholder meeting, bonds ought to come with a warning label these days.

Most fixed-income investors have no idea how badly they can get pounded when interest rates rise. And when rates jump quickly and unexpectedly, bond prices fall precipitously. Don’t make the mistake of believing you’ll somehow recognize the sell-off before it arrives.

As for holders of leveraged bond funds, they really need to strap on their cups. In a bear market in bonds, these funds can plunge like equities in a stock market crash. No one in their right mind should be holding these funds now. This is triply true if you hold a leveraged, closed-end fund that is trading at a premium to its net asset value.

In short, a decade ago investors should have learned not to invest in a bubble. Instead, their take away was they shouldn’t invest in technology and internet shares. When they took a drubbing in real estate, they should – again – have learned not to invest in a bubble. Instead, they concluded that real estate speculation can be unwise. Today – secure in their knowledge that they are not investing in either risky technology stocks or speculative real estate – they are shoveling money into the bond bubble.

Are experienced investors supposed to laugh or cry?

Good Investing,

by Alexander Green, Investment U Chief Investment Strategist


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