What happens when “safe” havens aren’t safe any more!

If there’s one thing many investors crave, it’s safe havens. Places where they can put their money and sleep at night, secure in the knowledge that they’ll at least enjoy the return OF their money, if not much return ON their money.

One thing is abundantly clear from the last several quarters of money flow data, as well as pure price action: Boatloads of investors are finding “safety” in bonds.

Lulled into a sense of security by the Federal Reserve’s interest rate pledges …

Sold on the idea that inflation will never return …

Convinced that bonds have virtually no risk …

They have bought bonds at a pace never before seen in the history of this country — and therein lies the problem! You see, any time an asset class has been overwhelmed with oceans of cash … in a buying frenzy encouraged by reckless central bank policy … it ends in tears. Every time.

Or in plain English, bonds may not be Phoenix single-family homes or Miami Beach condos. They may not be Pets.com shares. But they are every bit as massively overvalued, and massively overinflated by easy Fed cash, as those asset classes were before them. And I am firmly convinced we are headed for yet another Fed-fueled disaster, with only the asset class changing!

Look at the flow of money and tell
me how this ends well! Please!

If you want to know what’s really happening in the markets, just follow the money! For instance, the Fed right now is conjuring cash out of thin air and buying roughly 80% of all the Treasuries being issued. If the Fed were to stick to its announced buying plans through the end of 2013, it would Hoover up roughly 77% of ALL net issuance (new bond sales – redeemed/matured bonds) in the Treasury, agency mortgage bond, and investment grade corporate debt markets combined, according to RBS Americas.

The promise of that kind of buying back stop has lulled investors into the most complacent state in history! Case in point: The MOVE Index of Treasury market volatility (like the VIX, only for bonds instead of stocks) just hit an all-time record low a few weeks ago. The yield on junk bonds just hit the lowest absolute level ever, around 5.9%, while the spreads between yields on risky bonds of all stripes and yields on equivalent Treasuries have collapsed.

And following the money, you can see that investors are buying bonds like never before. Just look at the numbers from the Investment Company Institute, which tracks where mutual fund investors are directing their capital. The figures for December show the same thing the figures have been showing for ages now – money moving OUT of stocks and IN to bonds.

Equity funds lost $3.27 billion in the week ended December 26, while bond funds took in $2.46 billion. The week before? Stock funds lost $5 billion while bond funds gained $427 million in assets. The two weeks before that? $15.6 billion OUT of stocks, and $6.9 billion IN to bonds.

Add it all up, and you see that since January 2010, $297.7 billion has flowed out of stock funds. A stunning $671.4 billion has flooded into bond funds during that same period of time!

Now I’m not here to argue that people should have poured into stocks during this period of time. We’ve had a lackluster economic “recovery,” major credit problems in Europe, ongoing weakness at global banks, and more. But clearly investors have grown just as enamored with bonds as they used to be with dot-bombs and real estate!

Catalysts already coming together for a wipe out!

So what brings about the end of this massive bond bubble? Several forces that are already in play!

Start with the Fed backing away from its reckless buying plans. As Tom Essaye noted earlier this week, several Fed members are already worried about the detrimental impact of QE.

They’re worried it could spur inflation. They’re worried (as they should be!) that they are distorting the markets and encouraging massive, stupid risk taking among investors. They’re also worried that the Fed itself could lose huge amounts of money on bonds. It has become a giant warehouse of bonds, after all, and if rates go up and bond prices fall, guess who’s going to be left holding the bag?

Then there’s the threat of more ratings agency downgrades of our sovereign credit. Or a disaster in the negotiation over the debt ceiling, one severe enough to spook international bond holders. Or even the perception the economy is rebounding. That would boost inflation fears, and lead to another rash of selling.

Bottom line, if you’re hiding in bonds, you’re not really safe at all. You’re taking huge risks. In my view, the risk rises dramatically the farther out on the risk curve (meaning junk vs. investment grade) you are, and the longer-term your bonds are (say, 30 years vs. 2).

I recently made my thoughts clear on the junk bond market here. Now I would encourage you to consider exiting any long-term Treasury or corporate bonds, as well as mutual funds or ETFs that invest in them. Instead, for your fixed income money, stick to short-term, higher-grade bills and notes or equivalent ETFs and mutual funds. Specific names can be found in my Safe Money Report.

Until next time,

Mike