Business - Finance Some fear bond bubble may be ready to burst

By Bernard Condon

AP Business Writer

NEW YORK (AP) -- Maybe bonds aren't so dull after all.

Bad economic news sent investors out of stocks and into U.S. Treasurys this past week, extending a rally that has defied some of Wall Street's best minds, and, some say, logic. Treasury bonds maturing in 20 years or more have returned 21 percent so far this year. By contrast, stocks in the Dow Jones industrial average have lost 2 percent.

The question now: Is it too late to jump into the great government bond bonanza?

To bulls, the rally is still in its early stages. They say the weak economy will cause stocks to keep falling and people to seek the safety of U.S. government debt. Reports this past week of unexpectedly high unemployment claims and a manufacturing slowdown in the mid-Atlantic region helped bolster their case.

But others say Treasury prices have risen too high, perhaps even to bubble proportions. The thinking goes that investors could dump Treasurys as quickly as they bought them on even a whiff of inflation. Inflation is bad for bonds because it eats into principal.

Bonds are generally regarded as safer than stocks because you get your money back when they mature. But that's only true if you pay face value. If you buy when prices are higher, say $101 for a $100 bond, you'll get $1 less than you put in. In purchasing power, you get back even less thanks to inflation. But bonds, of course, also pay interest, and this can more than make up the difference.

The problem is, bond bears argue, the interest isn't compensating you much now. The yield on 10-year Treasurys, which moves opposite its price, stands at 2.61 percent, a low not seen since early 2009 during the depths of the credit crisis. At that rate, it would take you 27 years to double your money.

"In the long run we don't think you'll make a good return" in government bonds, says Mark Phelps, CEO of money manager W.P. Stewart & Co., citing the low yields.

Phelps suggests that investors worried about a stalled recovery should stick to stocks of big, conservative companies with little debt and fat dividends. Though you can still get hurt if their stocks fall, at least the dividends will help compensate.

An added appeal: The dividends offered by such blue chips are higher than current 10-year Treasury yields.

PepsiCo Inc., for instance, will pay you $3 annually now for every $100 you invest -- nearly 50 cents more than Washington pays for holding your money for 10 years. What's more, the stock is trading at 14.5 times estimated annual earnings. The median, or midpoint, over the past 20 years is 23 times estimated earnings, meaning the stock is cheap, at least by this one measure.

Phelps also likes Procter & Gamble Co. stock. It pays you even more than Pepsi -- $3.20 a year for every $100 invested. The maker of Pampers diapers and Pringles chips trades at 14.8 times estimated earnings, a discount to its 19 median.

"To put all in Treasurys, looks like a mistake to us," says Phelps, whose firm manages $1.5 billion. But he adds, "I would have said that at the beginning of the year, and I would have been wrong."

He's got good company.

For years, famed investors and economists have been warning that the price of Treasurys had risen too high. Bill Gross of giant bond firm Pimco said that Treasurys had some "bubble characteristics" in December 2008 when 10-year yields neared 2 percent. Nouriel Roubini, who gained near celebrity status after calling the crash, warned of a bubble about the same time. In a letter to his Berkshire Hathaway shareholders last year, Warren Buffett compared the "U.S. Treasury bond bubble of late 2008" to the Internet and housing bubbles.

However, as fears of an economic collapse receded last year, investors rushed into stocks and out of Treasurys, sending prices down and yields up. Now, as yields slip closer to their late 2008 lows, bubble talk has returned.

On Wednesday The Wall Street Journal published a letter from Wharton professor Jeremy Siegel and Jeremy Schwartz, director of research at Wisdom Tree Investments Inc., that likened Treasurys to dot-com stocks of the late '90s before they crashed. The headline: "The Great American Bond Bubble." They noted that yields on some bonds are the lowest in 55 years.

Their advice to investors will sound familiar: Buy blue chips with fat dividends.

Avi Tiomkin, chief investment officer of Tigris Financial Group and a Treasury bull for years, disagrees.

"Dividends are great as long as a company can make money," he says. "But if the economy sinks, they'll stop paying."

Tiomkin says he's sticking with Washington IOUs. A year ago he correctly predicted the 10-year yield would fall from 3.75 percent to around 2.50 percent by mid-2010. Now he foresees deflation, or a consistent and widespread fall in prices for goods and services similar to what afflicted Japan during the '90s. And that will drive more people into Treasurys, lifting prices and pushing 10-year yields to below 2 percent, possibly all the way to 1 percent, within a year.

Van Hoisington, president of an eponymous investment firm in Austin, Texas, who also foresaw the Treasury rally, is not buying all the bubble talk either. In his latest newsletter, he writes that "The risk, if not the probability, is that deflation lies ahead."

He recommends buying Treasury bonds, as he has done for years now. He has returned 11 percent over three years.

Jack Ablin, chief investment officer at Harris Private Bank, prefers stocks. But even he's worried.

Ablin notes that Federal Reserve interest rate cuts intended to spur borrowing and spending don't have much of an impact if people are swimming in debt and can't or won't borrow. If prices of consumer goods fall, he says, that will make matters worse as people defer purchases in hopes they can buy cheaper later.

"There is little (the Fed) can do but stand on sidelines with pom poms and cheer people on," he says.

Published: Tue, Aug 24, 2010