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Why bond bubble could be new 'fiscal cliff'

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The past decade has been one marked by quietly inflating bubbles that unexpectedly burst, leaving financial markets reeling, diminishing opportunities for profit and sending investors' life savings into unsettling flux due to volatile securities prices.

The burst and deflation of the technology bubble in 2000 sent markets spiraling downward and, exacerbated by the terrorist attacks of 2001, erased a stunning $5 trillion of market value in just two harrowing years. More recently, the burst of the housing bubble helped to weaken markets and played an integral role in the evaporation of $16.4 trillion in U.S. household net worth from spring of 2007 to the market trough in mid-March 2009.

Bubble bath

With the ever-imminent threat of total hysteria over daily market movements (thanks, in no small part, to the immediacy of reporting on 24-hour news stations drumming up advertising revenue through the creation of catastrophes, each complete with its own theme song), let's get a little perspective before we whip ourselves into a frenzy in search of the next big bubble poised to burst.

A "bubble" in financial markets is simply the trading of an asset or security at unreasonably high valuations (e.g., overpriced stocks) followed by a sudden devaluation of the security, or a crash in prices.

Bubbles are as old as currency and countless numbers of them in varying magnitudes have risen and fallen over hundreds of years. Just do an Internet search for "The Tulip Bubble" and you'll see what I'm talking about.

Madge, you're soaking in it

The funny thing about bubbles is that we often don't seem to recognize the formation and growth of a bubble until we suffer the detriment of its decline. The challenge in predicting even the existence of a bubble can sometimes be overcome with a reconciliation of bare facts.

Let's lay them out here and see what you think.

In the first three quarters of 2012, roughly $220 billion had flooded into bond mutual funds. Going back just a few years to the collapse of Lehman Brothers in 2008, over that period of roughly four years investors deployed a staggering $900 billion in cash to bond mutual funds.

Many investors look to bonds for safety of principal and stability (relative to equities and some other assets), and fear of investing in more volatile assets seems to have encouraged an exponentially increasing interest in holding bonds and bond mutual funds. What many investors may not realize is that you can, in fact, lose money investing in bonds.

The all-time record high prime rate in the United States was 21.5 percent on Dec. 19, 1980. This means that if you were purchasing a bond around that time, you were lending your money to a company or entity in exchange for a bond certificate that promised the entity would pay you interest (commensurate with the insolvency risk of the company issuing the bond) around that incredibly high interest rate.

In hitches and starts over the ensuing decades, at least until Dec. 12, 2012, that prime rate has decreased to its current (as of this writing) standing at 3.25 percent.

Knowing what we know about the effect that interest rates have on the value of bonds in the secondary markets (e.g., when interest rates increase the value of bonds decreases), one might deduce that the 30-year bull run on bonds will have to come to an end if rates are ever expected to go up.

To give you a sense of what this may mean to U.S. Treasury Bond investors, consider this:

A 10-year treasury bond issued at a 2.82 percent interest rate could see a 42 percent loss in value from a mere 3 percent rise in interest rates. Meaning, if you'd held $100,000 in these bonds prior to the rise in rates, you would be able to sell those bonds for only $58,000 in the secondary market after the 3 percent rise.

What to do?

At first glance, the bond bubble situation may seem dire, but the informed investor may find him/herself well positioned to take advantage of this seeming inevitability.

True, investors have often bought bonds in a flight to assumed safety; however, in times when even the seemingly "safe" investments threaten to veer into a range of volatility, what is an investor to do?

We counsel some of our clients to consider avoiding bond mutual funds in favor of purchasing the individual bonds themselves with an intention to hold those bonds until their maturity.

Fluctuations in the value of a bond that an investor had intended to hold until maturity should minimally affect the investor's long-term expectations of yield, if at all. Most bonds are redeemed at a flat $1,000 per bond. If a bond price fluctuates to a value of $900, $800, $700 or even lower, it could still eventually achieve redemption at "par" (that $1,000 value for most bonds).

This remains only one of many strategies to utilize this asset class with full understanding of the possibility of a coming storm and the ensuing rude awakening for complacent bond fund holders.

Bubbles come and go, of course, but with proper and prudent management and investment guidance, the average investor still can stand to gain from these perceived threats to our economy.

Anthony M. Conte is managing partner at Conte Wealth Advisors LLC in Camp Hill.

Fixed-income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

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