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BONDS MAY NOT BE AS SAFE AS YOU THINKBuying them now might mean you're buying at the market's topWith continued stock market instability, many investors are following a path that's heavily trod in times of trouble: They're selling stocks and buying bonds. They could also be making a big mistake. How? After all, bonds historically do well when stocks are falling and are a safe harbor for your cash during stormy times. Bonds, the assumption therefore goes, are less risky than stocks. In general that's true, but in the markets, all things are relative. And now, relatively speaking, bonds are just about as expensive as they've ever been. Stocks, on the other hand, are getting cheaper by the day. And as deflationary pressures build and the dollar rises, cash itself is becoming more and more of an attractive asset. Beyond that, bonds, despite their reputation as a haven, can sometimes swing just as wildly as stocks. Those swings tend to be in narrower bands than they are with stocks (it isn't often that a bond will lose 15% of its value in one panicky day, as Yahoo (YHOO) did on Aug. 31). But it's a misconception that bonds somehow have a limited downside. Just ask the hedge funds that loaded up on Russian government bonds rather than play the Moscow stock market -- and are now holding worthless paper. "The man who says bonds are not volatile has clearly never held one in his portfolio," says Hugh Johnson, chief strategist for First Albany. UPSIDE SWING. Right now, the U.S. bond market, which is admittedly light years safer than Russia's, is experiencing one of its wildest swings ever -- but to the upside. The benchmark 30-year Treasury bond, which is the most closely watched bond in the market, has a yield of 5.31%. That's lower than it has been for the last 30 years. At the beginning of the year it was at 5.8%. In other words, we're in the midst of a phenomenal bull market in bonds. And as bonds have grown in price and declined in yield, they become riskier to own. "It's clear that as yields go down, the risk level goes up," says Pat Retzer, head of fixed income at Heartland Mutual Funds in Milwaukee. It isn't just the long bond that is currently expensive. The 10-year bond, which is often used as a gauge for where mortgage rates are going, has seen its yield fall below 5%, another 30-year low. Meanwhile, the short end of the yield curve, which some think is being kept artificially high by the Fed's unwillingness to cut interest rates, is actually higher than the long end, with the overnight lending rate at approximately 5.5%. That, dear friends, is known as an inverted yield curve, and it doesn't occur very often. It also doesn't tend to last very long. That's because it goes against the basic laws of bond physics. The whole bond world is based on the concept that the farther out in time that lent money is to be returned, the greater the risk that the lender won't get it back or that the returned money won't be worth as much as it is today. An inverted yield curve usually means that something is very wrong with the state of bond. And it's often, though not always, a precursor to a recession. So why do we have an inverted yield curve right now? There are two main reasons. The first is that deflationary pressures have convinced the bond market that inflation really is dead. Without inflation eating away at the value of money over time, then it makes sense that it would cost more to borrow for the short term than it would for the long term. The second cause of the inverted yield curve is the "Flight to Quality," otherwise known as the "Dance of the Lemmings." As global markets collapse, and foreign currencies teeter, foreigners are desperately buying up the most secure investment they can, which happens to be bonds issued by the U.S. government. Thanks to the universal laws of supply and demand, this has caused the price of bonds to skyrocket and the yield, which always moves in the exact opposite measure as the price, to plummet. RISKY BET. If you had forecast that all this would happen around this time last year, when the long bond was yielding 6.61%, then you would be wealthy today. But the problem with moving into bonds now is that you can't invest for the previous time period, you have to invest for the future. Buying bonds now would mean that you expect them to perform even better -- and their yields to fall even further -- than they have in the recent past. And that is a very risky bet. You don't have to look back very far for a sobering reminder of how quickly the bond market can turn on investors. In October, 1993, the long bond yielded 5.97%, and the bulls were galloping at full speed. One year later, the yield had risen to 8.15%, and many bond mutual-fund investors had lost as much as 30% of their portfolios. While the economic situation is very different today than it was in 1994, it's still true that the direction of bond yields is very difficult to predict. So where is a safe place to put your money now? Each time the stock market falls, it becomes safer. But few expect the volatility that has characterized the past few weeks to go away any time soon. If you insist on trying to sell out of the stock market just when it's becoming cheaper, try cash, not bonds, says First Albany's Johnson. "Every investor should understand that the best way to shore up the defenses of their portfolio is in cash right now," he adds. Whether that means redeeming stock for greenbacks or simply reinvesting the money in bank CD or short-term money market funds doesn't matter. If you believe in the concept of buying low and selling high, this doesn't look like the right time to put your money into bonds.
By Sam Jaffe in New York RELATED ITEMS
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Updated Sept. 3, 1998 by bwwebmaster
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