Watch the Signs: Next Bubble Will Be in Bond Funds

I have been in this industry for almost 25 years now, and been following the financial markets since I was in high school. I have had a strange ability to “sense” bad things, markets or investments that were amiss, and normally these feeling are associated with major events; from the 1987 crash to the 1994 derivative debacle to the tech bubble and most recently, when I began pounding the table in August 2007 that risk was high, and problems were coming. Many have asked me to share when I see or feel the next big one, and that is the reason you are getting this message. My radar may or may not be right, but I promised I would share it. At precisely 2 a.m. last night, I awoke and it was as crystal clear as could be, so much so that I got up, showered, and raced to the office .

Over the past couple of months, my firm has been asked: Are we in a bond bubble? That was the easy thing to see. But too many saw it, have acted on it, and it just didn’t feel like the big one to me; my radar wasn’t up on that. I wondered if I was missing something, but I went back to my thoughts around August of 2007, when virtually no one at my office saw a big event coming. And while I rambled about it, the naysayers were abundant. This current environment of a “bond bubble” and buying TBT and TMV seemed too easy, and too many were following it. The one component of a classic bubble, one that may have kept my radar down, was that normally there is a large loss potential, and with individual bonds, the investor could hold till maturity, and thus not suffer a loss (unless the underlying credit defaults, which is a story for another occasion). And then at 2 a.m. it hit me: It’s not bonds that are in a bubble, it's bond funds and the bond fund shops… it's PIMCO! Or others, but I like picking on PIMCO.

We haven’t been around for 35+ years and not figured out a way to avoid the November axe. We are a survivor and our clients are not going to be Turkeys on a platter. You may not be strutting around the barnyard as briskly as you used to -- those near 10% annualized yields in stocks and bonds are a thing of the past -- but you’re gonna be around next year, and then the next, and the next. Interest rates may be rock bottom, but there are other ways -- what we call “safe spread” ways -- to beat the axe without taking a lot of risk: developing/emerging market debt with higher yields and non-dollar denominations is one way; high quality global corporate bonds are another. Even US Agency mortgages yielding 200 basis points more than those 1% Treasuries, qualify as “safe spreads.” While our “safe spread” terminology offers no guarantees, it is designed to let you sleep at night with less interest rate volatility.

Why would he say that?

Over the past year or so, the herd has flocked to bonds and bond funds. The demand has been greater than the tech-bubble demand back in the late 1990s. Bond funds have seen immense flow, and bond fund shops have created new and unique funds to support all this demand. And the issue that these funds have is that they have to generate yield to keep investors happy, and to gather new assets. Instruments used are completely unfamiliar to investors, from leverage, to derivative, to junk, to emerging markets, to swaps, to... . As I always say, it works 'til it doesn’t.

From Barron's…THE ALWAYS INNOVATIVE BOND KING, PIMCO, home of $247.9 billion PIMCO Total Return, the world's largest mutual fund, continues its quest for new sources of yield.

The Allianz (AZSEY) unit last week launched the PIMCO High Yield Spectrum Fund (PHSDX), which will pursue the bonds of junk-rated companies throughout the world with no rating-weight restrictions.

Back in 2007, there were some initial cracks. That seemed odd but no one really thought much of it; it was a correction, short term, not a big problem; contained as the Fed said. It feels like some weird stuff (that’s a technical term) is starting to happen.
 

1. QE2 was announced and the Fed said they would buy Treasuries, especially in the 5-7-yearish part of the curve. One would think that would create a ceiling in that part of the curve as investors know the Fed will be a buyer. Yet over the last week, the 5-year has gone from 1.15% to 1.5%. That’s a huge move in a short period of time.

2. The move seen in a number of MUNI closed-end funds is amazing. Check out the charts of the Nuveen Muni Trust (FAAC), and the INVESCO “Quality” Muni Trust (IQI). Ouch.

Take a look at the page in the Wall Street Journal that contains the closed-end funds, and look at each of their yields. How in the world are they generating these numbers? It works 'til it doesn’t. Take a look at PIMCO’s fish shares in their SMA, take a look at their Total Return Fund and its holding, they are using any and all tools to produce yield. This has catastrophe written all over it, and my guess is that Bill Gross knows it. But when you run a trillion-dollar shop, it’s almost impossible to get out of some of this stuff. And with the retail crowd in, the institutional crowd in, the Fed in, the foreigners in, who’s left to buy when the selling comes -- the door ain't big enough.

And the last piece of the puzzle may have been last week, when sitting in a senior SB FA’s office in Los Angeles, he asks me for my opinion on PIMCO. And his comment was basically that because no one really knows what PIMCO does, how it does it, that when problems arise and losses occur, the lawsuits will start. He sees a lot of foundations, endowments, municipalities, etc. that use PIMCO, and will sue for losses for “inappropriate investments." And the snowball would begin.

So in summary, we have all the classic signs of a bubble in bond funds and bond fund shops.
 

• The retail crowd is in;
• They don’t think they can lose;
• It’s a new paradigm (bonds);
• Nobody sees it.

We need to start planting seeds with all of our contacts to let them know they need a safe haven, that they shouldn't use yield-enhancing instruments, that they have made money in their riskier bond funds and now need to keep it. The easy things for FAs to do in 1999 was to “sell” tech and growth funds to their clients. The easy thing to do in 2006 and 2007 was to sell housing- and financial-related stocks and funds to their clients. The easy thing to do right now is to sell yield-oriented funds. You can see a pattern here. The investing public needs us now more than ever!

This is your wake up call. Go to work.

Steve Smith's OptionSmith portfolio is +40% in 2010. Take a FREE 14 day trial to get exclusive access to the portfolio and trade alerts emailed to you before every trade. Learn more.