Montreal, Canada

Though I’m still bullish on bonds heading into the last four months of the year, I reduced my exposure to 30-year Treasury’s by 50% last night. I’ve banked some nice profits since earlier this summer and I think we’re seriously overbought at these levels.

Credit spreads continue to tighten this summer and, for the most part, bonds aren’t cheap. Since March 31, 30-year T-bond yields have crashed from 4.75% to 3.69% this morning – a pretty big rally. News the Fed is considering QE II or another round of asset purchases later this fall drove yields even lower last month as investors ride the Fed’s tailcoats.

Bonds are now fair value at best – all bonds.

The great values heading into 2009 are now largely gone with mutual fund inflows going haywire over the last 12 months as investors chase yield. Flogged by the credit crisis two years ago and still about 30% below their October 2007 highs, investors have shunned equities in favor of bonds. An entire generation of investors has basically given up on equities since 2008.

Investors have already sifted through the deepest bargains and credit spreads at these levels don’t look especially enticing. There isn’t one subsector of the bond market that looks cheap.

But mutual fund investors can’t get enough with record inflows continuing through August at the expense of domestic stock fund flows.

You’ve got to wonder how much longer this bond bull market will last considering the low level of interest rates. Even the bond bulls believe rates will trough around 2% or so on the benchmark ten-year Treasury bond; if that’s the case then why speculate now with 10-year T-bonds yielding 2.6%? Is it really worth the risk?

If you need income a good strategy is to ladder your bond portfolio up to five years. I’d keep my duration short at these prices and diversify among the entire gamut of spread product like T-bonds, corporate investment-grade bonds and other fixed-income securities that are rated investment-grade. If you prefer professionals managing your assets then consider Bill Gross at PIMCO Total Return Fund (PTTDX) and Dan Fuss at Loomis Sayles Bond Fund (LSBRX). Nobody does it better.

I would, however, avoid municipal bonds at all costs since some sort of dislocation seems likely in the absence of tax revenue growth and contracting economic activity in many states across the country. I have no doubt that some states will require a bailout from Washington at some point.