About the Author Tom Zachystal (CFA, CFP) is President of Individual Asset Management, a Registered Investment Advisor specializing in investment management and financial planning for expatriates.

Over the last four years retail investors have largely put their money into bonds and, to a lesser extent, non-US stocks. Money flows into US equity mutual funds have been negative each year in the last four. This trend has been especially prevalent in the last two years, even as equity markets outperformed bond markets.

Just recently we have seen a cross-over; with investors selling bond funds and money starting to flow into equity funds – especially US equity funds.

We should ask whether we are not seeing the initial stages of the bursting of a bond bubble. I think this may well be the case - at a minimum it seems there should be a re-balancing toward stocks.

The case for fixed income investment has to do largely with demographics and fear. As the general population ages it is natural that investors put more money into more conservative income-producing investments. Also, there is still considerable trepidation amongst investors who lived through the equity downturn of 2008. Furthermore, whenever there is political or economic uncertainty, investors still run to US Treasuries.

However, the cards seem stacked against bonds. At a minimum, we might expect there to be a re-balancing at some point as investors diversify their bond holdings into other asset classes. But there is more to consider:

· Interest rates are very low in most developed economies, and surely must rise at some point - a negative for bond prices.

· Sovereign debt has increased dramatically in the US and many European countries - this could lead to credit downgrades or even defaults.

· Many US States and municipalities are also having difficulty meeting their debt burden requirements - bad news for municipal bonds.

In my opinion, the risks outweigh the benefits with respect to bond investment at this time. This view is also shared by the vast majority of professional investment managers whom I have heard speak at the various 2011 forecast events. The world’s largest bond fund management company, PIMCO, has recently diversified its business to stock funds and its Chief Investment Officer, Bill Gross, has commented that the best years for bonds seem to be over. Just recently the Financial Times and Wall Street Journal published articles stating that PIMCO had sold all it’s US Treasuries.

It is important to understand why bonds and bond funds are at risk in a rising interest rate environment and which investments are most at risk: Suppose you purchase a newly-issued 10-year US Treasury bond for $1,000. Perhaps you may be receiving 3% interest and you can consider this to be a risk-free investment in the sense that you expect ten years from now that the US government will re-pay the bond’s par value.

Now suppose it is five years later, interest rates have risen and newly-issued five-year US Treasuries can now be purchased that pay interest of 5%. Certainly no investor would give you $1,000 for the bond you own, which now has five years to maturity but only pays 3%. So the price of your bond must fall to the point where a new investor would be indifferent as to owning the new 5% bond or your 3% investment. In this example, over the next five years your bond will pay $150 in interest (3% x $1,000 X 5) and the 5% bond will pay $250 in interest, so perhaps the investor would be content purchasing your bond at a $100 discount, for $900; since at maturity the US government will pay $1,000 on the bond, which would make up for the $100 in foregone interest.

Two points are apparent from the example above: Bond prices fall as interest rates rise and the longer the term of the bond the greater the price volatility. Just to clarify the last point: Suppose interest rates had risen to 5% in two years instead of five. There would be eight years’ worth of interest payments still left on your bond; $240 worth of interest. The new 5% bond would give eight years’ payments at 5%, for interest of $400, a difference of $260. So in this case a new investor might only be willing to pay $740 for your bond in order to be able to recoup the loss of interest over the eight years to come.

In addition to interest rates, one must also consider declining credit quality as a risk to bond prices, as well as investor sentiment and inflation. If inflation is 5% and you have a 3% investment, then you are losing 2% a year in inflation-adjusted terms.

Finally, many investors use bond funds rather than individual bonds. In the case of funds, there is no set maturity date when you can get back your principle and so there is an added element of uncertainty having to do with the management of the fund. On the plus side though, bond funds can offer convenient diversification; especially for smaller investors.

This article is for informational purposes only, it is not intended to offer advice or guidance on legal, tax, or investment matters. Such advice can be given only with full understanding of a person’s specific situation.

Individual Asset Management is a U.S. Registered Investment Advisor; Tom Zachystal is a Chartered Financial Analyst, and Certified Financial Planner™ professional with over ten years expatriate portfolio management and financial planning experience. He has clients on four continents in over a dozen countries and is one of the original members of the Expat Focus Trusted Partner Network, a small group of financial advisors selected specifically for their professionalism and integrity. His services include: US or offshore investment accounts, IRAs, 401ks, portfolio/investment management, UK SIPPs, UK pension transfer to the US or elsewhere (QROPS), retirement planning and other financial planning services for US citizens living abroad or residents of any nationality living in the US.

Click here to send Tom a no-obligation enquiry for financial advice.