Is the bond bubble ready to burst? Well, that depends on whether it ever existed in the first place.

Bonds, the traditional safe harbor, have enjoyed a helluva run amid one of the worst bear markets in history. During the last three years, a ton of cash has poured into fixed-income vehicles such as bond funds, which have capitalized on the fear generated by a precipitous decline in stocks. Assets under management in bond funds have increased 51% from $792 million in March 2000 to $1.2 trillion at the end of February, according to the Investment Company Institute.

But with the bulk of intense fighting in Iraq nearly over and Saddam Hussein's murderous regime in shambles, investors are wondering what that portends for the bond market. Will this be another dot-com meltdown? Not quite.

The word bubble often implies that there is an overbought condition or a case of "irrational exuberance." Certainly, bond inflows have reached epic proportions, a trend best illustrated by Bill Gross' $72.6 billion PIMCO Total Return fund, which rose to the top of the mutual fund heap last year, dethroning the storied Vanguard 500 index fund. But one would be remiss to say that the success of bonds is limited to three years of frenzied buying. On the contrary, declining interest rates have sparked a strong bull market for bonds for more than 20 years, with the exception of a few brief periods of steep losses.

"I don't think that in any real way it is a bubble," said John Canavan, Treasury market analyst at Stone & McCarthy Research Associates. "There are too many good reasons for yields being where they are."

Despite the buzz about a bursting bond bubble, there hasn't been a massive migration from bonds to equities. Typically, when there are big movements in both markets. it is a lopsided affair, Canavan said.

He noted that at the front end of the yield curve, which consists of shorter-term notes, the Fed funds target rate is easing. And at the long end, where inflation is the primary concern, "there is just no inflation out there right now," Canavan said.

With the war against Iraq already priced into the market, concerns over fundamentals, earnings and unemployment are creeping back to the forefront. If the post-war economy doesn't bear fruit, chances are the front end of the curve will test the lows it hit back in early March of this year. That could force the Fed to cut interest rates at the next meeting of the Federal Open Market Committee in May, which would be deemed a positive catalyst for bond funds. As yields decline, the value of existing bonds increases because they offer higher income.

Fed chairman Alan Greenspan has said repeatedly that discerning the economic path will remain difficult until the dust settles in Baghdad. But that day is drawing closer and recent economic reports have suggested that conditions are not improving "If that's the case, then regardless of other factors, the front end will be forced to remain at exceptionally low yields," Canavan said.

Canavan believes that members of the Fed, much like everyone else, threw up their hands and said "You know what? We're not sure." After its March 18 meeting, Greenspan uncharacteristically refrained from commenting on the Fed's outlook for the economy, citing "unusually large uncertainties clouding the geopolitical situation." His fence-sitting was met with a degree of confusion on Wall Street, causing some traders to question his game-planning.

Concerns about the landscape of a post-war economy have actually grown since Greenspan's comments. Indeed, the U.S. economy lost 668,000 jobs in the first three months of 2003 alone and the Institute for Supply Management's manufacturing index has plunged to 46.2 in March from 55.2 in December, its fourth consecutive month of declines.

Canavan, whose firm still doesn't have a strong opinion of exactly what the Fed is going to do to stimulate growth, said it is going to wait for further economic data from the government before making a definitive call.

But the bigger question for bond investors is whether the economy will bounce back once the war has officially ended. There are a number of geopolitical wild cards still out there, including North Korea, potential terrorist retaliation and diplomatic relations with other Middle Eastern nations.

Still, investors should steer clear of putting all their money in bonds because it is foolish to chase past performance no matter what the economic landscape. One doesn't have to look further than the tech-heavy growth funds of the late 1990's to see the proof in the pudding. And there's no reason to expect that that pattern won't also play out with bonds, especially if we see an uptick in the economy.

If the economy can regain its footing, then there is clearly an upside for yields and a downside for prices. "Yes, bonds have done tremendously well, but all good things must come to an end," Canavan said.

Copyright 2003 Thomson Media Inc. All Rights Reserved.,

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.