Bond bubble may deflate slowly

By Hibah Yousuf | CNNMoney.com

The bond bubble debate is far from over, but experts largely agree that interest rates are not going to shoot sharply higher anytime soon.

While 90% of the nearly 30 investment strategists and money managers surveyed by CNNMoney expect long-term rates will rise throughout 2013, their year-end target on the 10-year Treasury yield is just 2.14%. That's only a little more than a quarter of a percentage point higher than where rates are now and also not that much higher than last year's record low of 1.4%.

If bonds are in a bubble, it has just "started leaking air," said Phil Orlando, chief equity market strategist at Federated Investors. He added that "the bursting of the bubble would be more severe" if the Federal Reserve wasn't keeping rates low and buying $85 billion in bonds and mortgage-backed securities each month.

Fed chairman Ben Bernanke has reiterated time and time again that he will keep stimulus measures in place until the unemployment rate falls to 6.5% or inflation exceeds 2.5% a year. Most Fed officials don't expect those levels to be met until 2015.

Meanwhile, Europe's debt problems are far from over. Greece, Spain, Italy and Portugal continue to struggle. The euro crisis could keep U.S. bond yields low because it may continue to make U.S. debt look safer and more attractive to buyers around the world.

"There is a Treasury bubble that's been artificially inflated and will burst, but we don't expect to see a phenomenal blowup that will take the 10-year yield up to 5% for a couple of years," he said.

Though experts agree that bond yields won't soar too much this year, they don't believe investors should add to their bond positions either.

"Even if rates stay low for a little while longer, bonds are a pretty lousy investment," said Adrian Day, president of Adrian Day Asset Management. "Investors buying bond funds at this point are getting a very low return, with very little upside and lots of potential downside."

The value of bonds declines when interest rates move higher. Since rates are unlikely to fall much lower, investors could get stuck with steep losses if they wait to sell until after rates rise.

David Smith, chief investment officer at Rockland Trust, said individual investors are "especially exposed" to a big spike in bond rates since they've been flocking to bond mutual funds for the past several years in search of place to park their cash.

According to Investment Company Institute, individual investors have plowed more than $1 trillion into bond funds in the aftermath of the financial crisis.

"I don't think average investors understand how much they stand to lose," said Smith. For example, if the 10-year yield moves from 2% to 2.5%, a bond mutual fund with a 10-year duration would lose 5% in value, he said.

"And it's conceivable for the losses to be worse," he said. "Once the snowball begins, we could see massive redemptions, and that will feed on itself."

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