Fixed-Income Pros Fear 'Bond Fund Bubble'

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A higher yield on a bond makes it more attractive to new investors but hurts its market value for current bondholders.

There remain glimmers of hope for bond investors. "Rising rates are not a foregone conclusion," says J. Michael Martin, president of financial planning firm Financial Advantage in Columbia, Md. A weak economy could keep the Fed from raising interest rates. Even if the Fed raises short-term rates, long-term rates could remain low if the threat of inflation seems limited.

long-term bonds face greatest risk

If you own an individual bond, its market value may not be relevant to you. You can simply hold it until it matures, when—assuming the issuer remains creditworthy—you will be repaid in full. However, Martin notes, by holding onto the bond for so long, you may miss out on other investment opportunities. In a higher-interest-rate environment, for instance, other bonds may offer more income.

Most retail investors can't afford to own individual bonds, and even wealthier investors often prefer the lower costs and diversification of bond funds. Higher interest rates are likely to hurt the net value of these funds, particularly funds that hold long-term bonds, says Bill Larkin, fixed-income portfolio manager at Cabot Money Management in Salem, Mass. "Long-term [bonds] can really take a hit if the rate environment changes rapidly," Larkin says. Medium-term bond funds have greater flexibility to make up for market losses by moving into higher-yielding bonds, he says.

While Larkin suggests investors move from long-term to medium-term bond funds, he also suggests diversifying with an array of exchange-traded funds that includes exposure to gold, commodities, bonds, and stocks.

Cohen suggests that investors also "take some profits off the table" and move out of longer-term bonds. She suggests safer, short-term bonds. For investors seeking a relatively stable alternative to bonds, Prudential Financial (PRU) market strategist Quincy Krosby recommends high-quality, large-cap stocks.

Although many economists predict a strong economic recovery, the opinion is not unanimous. Economic events might wreak unexpected effects on the bond market, which Larkin calls "impossible to predict." The warning from investing pros to bond fund investors is that the bond market could be entering a period of higher-than-normal risk, and investors need to be aware of those dangers.

The next three years could be interesting times for bonds, Florance says. "This is not time to get lazy with your fixed-income portfolio," he says.

Steverman is a reporter for Bloomberg Businessweek's Finance channel.

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