Montreal, Canada

Bond fund inflows continue to hit records this year as investors lunge after yield. And credit spreads are still in the process of tightening – possibly setting investors up for a brutal bear market when interest rates eventually rise.

Driven in part by the collapse of most risk-based assets starting three years ago, investors’ mindset has changed as asset allocation psychology shifts into defensive mode. But as I’ve detailed here over the last several weeks, fund-flows point to a bubble brewing in fixed-income markets as investors are typically late to most parties in the financial markets. Bulging fixed-income fund flows signal danger ahead the same way booming fund flows back in the late 1990s signaled an equity bubble in high-tech stocks.

Meanwhile, values are becoming scarce in the credit markets.

Spreads, or the difference between benchmark ten-year Treasury bonds and speculative credits, have compressed markedly over the last eighteen months. Nowhere is this more pronounced than in emerging market debt spreads; emerging market bonds are the best-performing bond category since 1992. Once high inflation-prone countries that dominate the index – Brazil, Mexico, Russia – now harbor some of the lowest bond yields in history. They’re among the strongest currencies over the last ten years.

The J.P. Morgan Emerging Markets Bond Index yields 5.58% and has gained more than 21% over the last 12 months. The spread on this benchmark trades at just 300 basis points over Treasury bonds and is closing on the 52-week low of 242 basis points.

Investment-grade debt is also in high-flying mode. The Dow Jones Corporate Bond Index has gained 13.7% over the last 12 months and yields 3.51% or 90 basis points over Treasury bonds. That spread is now almost a healthy differential, busted by the credit crisis when spreads leapt more than 700 basis points for a short time.

I would not buy bonds of any variety now. The markets are way overbought in credit and a major pullback lies ahead. Unfortunately, the bond bears will have to wait for the inevitable explosion; another severe stock market correction looms and that event will drive yields even lower – except junk bonds, which should be sold.

Bonds are undeniably in a bubble. The only reason why someone would buy bonds now is because they expect a major recession to unfold over the next several months. Judging by where yields are now that supposition is a growing possibility.