Bond Bubble Grows Even as Bearish Pros Get More Optimistic

Battered investors rushed to buy safe assets in the wake of the financial crisis. Despite the meager yields offered by seemingly risk-free securities like U.S. government bonds, investor appetite was understandable.

Luminaries from the investment world, after all, had taken to calling for a new era of anemic economic growth where weak corporate profits and tepid stock market gains would be the norms. A goal of simply not losing more money overtook seeking positive returns as an investment strategy for many.

That was then. Now, as the U.S. economy shows slow but steady improvement, a major disconnect may be shaping up. The frenzy for bonds has only grown over time, despite mounting evidence that the worst fears voiced during the depths of the downturn were overblown. And investors are piling in even as some of the most prominent bearish voices seem to be shying way from their prior doomsday positions.

Bears Equivocate

For example, Mohamed El-Erian, co-chief investment officer of bond giant Pimco, has long been convinced of an anemic recovery and helped make the "new normal" a household term. But El-Erian recently pegged the chance of the negative scenario at just 55%, or barely over half. "It is our base case, but it's not our dominant case," El-Erian recently told Bloomberg News.

Likewise, bearish pundits who saw little risk to owning bonds and predicted an 80% chance of a double dip just months ago find themselves under siege. Gluskin Scheff chief economist David Rosenberg is now taking heat for attempting to morph his opinion that another downturn was likely into a position that the recovery is merely lackluster.

But while the bears seem to be backing down from their most pessimistic views, investors are rushing into assets like bonds that could get hammered if prices rise faster than the consensus currently expects. That would increase the risk of inflationary perceptions, making yields relatively less attractive given rising prices and reduced purchasing power.

Last week's $1.25 billion issue of a 50-year bond with a yield of 6.125% by none other than investment bank Goldman Sachs (GS)was the latest sign that a bubble may be further inflating in bond market. Commentators have been quick to point out that the long duration and low rate may mean the firm sees a top in the bond market, just like it was able to profit from the downturn in the housing market turn by making a bet home prices would decline at the point many thought rising home values were a certainty.

The Goldman move follows an issuance by Mexico where the country was able to raise $1 billion with promises of a payback a century later.

Fed Isn't Helping Matters

For the time being, investors seem to be overlooking signs that widely paraded forecasts of deflationary spirals might be overdone. Witness investors' continued appetite for corporate debt, even though in many cases stock in the company would make for a far better bet.

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This predisposition toward seemingly safe bonds is being reinforced by the machinations surrounding further easing by the Federal Reserve. Whether and how much in Treasury bills the Fed buys to drive rates lower in the hopes of kick starting the recovery remains a hotly debated question for the markets.

If the Fed does ease, buying Treasurys would pay off in the short term. But investors with any longer of a horizon should be aware of the dangers introduced by the Fed trying to ignite inflationary forces.

While inflationary data remain muted for now, consumer spending came in surprisingly strong in the preliminary third-quarter GDP report. The economy, in other words, may be staging a brisker recovery than investors might be anticipating.

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"Bondholders, while immediate beneficiaries, will likely eventually be delivered on a platter to more fortunate celebrants, be they financial asset classes more adaptable to inflation such as stocks or commodities, or perhaps the average American on Main Street who might benefit from a hoped-for rise in job growth or simply a boost in nominal wages, however deceptive the illusion," Pimco's Bill Gross wrote recently.

The legions of investors who were scared into buying bonds following the financial meltdown should note the change in perspective of some of the most bearish strategists. If not, they may soon find the biggest danger to their portfolio comes from holding low-yield bonds for too long.