The last century ended with a dot-com boom, followed by a real estate boom with each ending in a bust. Could bonds face a similar fate?

According to Bandon Capital Management of Portland, Ore., bonds are another example of "an overly crowded asset class" with more downside risk than upside potential. Moreover, the usual approaches to fixed income investing may have to give way to innovative "long-short" strategies.

As Bandon points out in a new whitepaper, 15 times as much cash went into bond funds from 2009 to 2011 as in the previous nine years. The bond boom accelerated in the first half of 2012, when 88% of total investments went into bond funds. As a result, interest rates are at historic lows, with little room for further declines that would bolster bond prices. "The risks associated with interest rates are out of line with what investors can expect to receive," Bandon chief investment officer William Woodruff, author of the whitepaper, said in an interview.

Here are the numbers, as Bandon crunches them:

  • Falling rates. Suppose rates drop another 100 basis points on the 10-year Treasury. Investors would enjoy an 11.47% total return in three years.
  • Return to normal. A 200-basis-point increase in 10-year Treasury yields would bring the real (after inflation) yield near the historic average. Investors would have a negative total return of 9.53% over three years.
  • Rising rates. The vast amount of liquidity injected into financial markets recently could lead to rising inflation and higher interest rates. Boosting 10-year Treasury yields by 400 basis points would produce a negative total return of 23.53% in three years-more than twice as great as the positive return from falling rates.

Thus, high-quality fixed income has an unattractive risk/reward profile, Bandon asserts. Moreover, some popular solutions may not work. Going from Treasuries to corporate bonds, for example, introduces credit risk yet still retains exposure to rising interest rates.
What about laddering? Some investors buy bonds with staggered maturities, so they'll have regular redemption proceeds to reinvest if rates rise. "Laddering would only accentuate the problem because the yield curve is steep now," Woodruff said. "With, say, a 5- to 10-year ladder, investors would get very little return from the shorter duration debt."

Some investors may consider replacing paltry bond yields with higher stock dividends, but Woodruff doesn't believe that's necessarily the best answer. "Moving assets from bonds to dividend-paying stocks skews an investor's asset allocation," he said. There could be more volatility and more correlation to equity markets.

Instead, Woodruff advocates long-short debt as a solution. That doesn't mean holding some long-term bonds and some short-term bonds; instead, investors would go long in some areas of the high-quality fixed income market and go short in other areas. "If done correctly," he said, "investors can maintain the lack of correlation of bonds to stocks, even in stressful times, and manage interest rate risks."

Woodruff promises more detail on his long-short approach to fixed income in a forthcoming whitepaper.