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Thursday, December 9, 2010

Long Term Bond Bubble Bursting ? What Will Retail Investors Do ?

I have written for quite awhile that in the bond market it has been the dumb money buying long term treasury and corporate bonds and "smart money" corporations grabbing the cheap money by issuing record amounts of corporate bonds. The low long term rates were unsustainable. Yesterday's bond sellofff attributed by some to the higher growth and larger deficits that may come out of the tax proposals show how violent the moves can be in long term bonds.

Retail investors have been flocking into bond funds for the last year or more. Supposedly this was in search of "safe investments" compared to the volatile stock market where they had suffered losses. In fact I would argue they weren't looking for safety but rather chasing returns of the most recently outperforming asset class.

These investors were simply riding the last wave of a massive decline in interest rates/rally in bonds. The positions were hardly "safe investments" particularly if they extended maturities in their bonds to avoid the paltry yields in the short maturities., As rates went down the longer duration bonds gained disproportionately compared to other bonds, I assume for some investors this was evidence their bond investments were ""safer" than stocks.

But as these investors are probably just starting realize, what goes up the most can go down the most, Those long duration bond holdings will suffer greatly should rate rise. Just the relatively modest increase in long term rates of late has been quite damaging to holders of long term bonds. Over the last 3 months TLT the 20 year+ treasury bond etf has declined 8.3% while the short term treasury bond etf SHY is unchanged. Surely all bonds are not equally "safe" investments

One very interesting question is how the "new" bond market filled with many,many more returns chasing retail investors (as opposed to a market in the past dominated by institutional investors) will react when rates bottom and they start to seee losses in their bond funds. If many of them run for the exits at the same time it could get ugly, More on that in the future.

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