Even after the magnificent run-up in bond values, investors will stay loyal to bonds and bond funds. By Jeffrey R. Kosnett, Senior Editor November 5, 2009 Stocks jump 50% in six months and everyone gets nervous. But bonds stage a spectacular rally and our reaction is to throw hundreds of billions more into the pot. Bond investors are so content and complacent right now that few are inclined to take their profits and run. Yet bonds can -- and do -- get overpriced. I’m not talking about dumping Treasuries, which some analysts insist are in bubble territory. My subject is investment-grade debt issued by U.S. companies. These bonds, rated from triple-A to triple-B, currently yield 5% to 6% for maturities of ten years and up. As the Dow Jones industrial average moved in fits and starts all summer and into early autumn to retake the 10,000 mark, long-term corporate bonds relentlessly continued to appreciate. Over the past 12 months through October 8, high-grade corporates returned 26%, more than twice the return of the stock market and three times the gain of Treasuries. Surprising results. Consider a few examples of how things have changed since early March, shortly before stocks and many bonds bottomed. On March 5, Appalachian Power, a healthy electric utility owned by American Electric Power, sold bonds maturing in 2020 and yielding 7.95%. Since then, the price of those bonds has climbed 23%. Meanwhile, AEP’s shares, which yield less than the bonds, lagged until October, when their year-to-date gain finally drew even with that of the utility’s bonds. Wal-Mart bonds have appreciated steadily since early March, while the giant retailer’s stock stagnated. The story is similar for Verizon’s stock and its bonds. Much has been made of how most bonds have handily outperformed U.S. stocks over the past ten years. One obvious reason is that stocks experienced two vicious bear markets. Another is that bonds’ higher yields provide a sturdier floor under prices during financial upheavals. Plus, bonds are benefiting from invisible yields on money funds and certificates of deposit. “The vast majority of the cash that’s leaving money-market funds is going right into the bond market,” says Mary Ellen Stanek, chief investment officer of Baird Advisors, a Milwaukee investment firm known for its excellent bond funds. Advertisement But something else is at work in favor of bonds: Investors are changing the way they think and behave. Karl Mills, a partner of Jurika, Mills & Keifer, an investment firm in Oakland, says that as investors deleverage (that is, reduce their debt levels), many want their portfolios to provide dependable income, and increasingly see money as savings to manage carefully and not as chips to make bets on the next big thing. I interpret this to mean that even after the magnificent run-up in bond values, investors will stay loyal to bonds and bond funds. The same people who unload their stocks after the market drops 5% or 10% are far less likely to ditch an American Express bond with a market value that drops from $1.20 on the dollar to $1.10 (although a move of similar magnitude in the stock market would lop roughly 800 points off the Dow). Corporate-bond prices may be nearing a top. Investors have been pouring money into bond funds, a contrarian indicator if ever there was one. Businesses are floating enormous volumes of bonds to take advantage of high demand and low interest rates. At some point Treasury yields will rise, pushing up corporate yields and knocking down bond prices (remember, bond prices move inversely with yields). For now, Treasuries are proving to be remarkably resilient. In fact, with widespread price reductions and pay cuts, there’s renewed talk of deflation, which should keep a lid on Treasury yields for the foreseeable future. Last March’s “super sale” on bonds, as Stanek calls it, is over for now, so it’s too late to buy bonds aggressively. But that’s not the same as forecasting a disaster. Keep your bonds and bond funds. They’re serving you well.