Is There A Bubble In The Bond Market?

Conditions in the bond market don't match the textbook definition of a bubble, but aggressive bond investors are positioning themselves to lose stunning amounts of money.

Interest rates are currently near all-time lows, and there's a heated debate as to why. Optimists will tell you that rates are low because global governments and central banks are stimulating the world economy. Pessimists will tell you that rates are low because we are on the verge of something terrible. A recession, a depression - call it what you will, but it will be so bad that prescient investors are content to lock in today's rates for the long term. "DM Intl."

Of course, we know that the optimists are on the right track, at least to some degree. Government intervention has created distortions in the bond market. The Federal Reserve has set the target federal funds rate between 0 percent and 0.25 percent, and is buying up U.S. Treasury bonds. By doing this, it has caused interest rates to drop across the board. From mortgage rates to bond yields to the interest rate on your bank account, rates continue to decline.

As for the pessimists? It is impossible to say at this point whether they will be vindicated, but it's clear that investors share their concerns. The last decade has scared many investors away from stocks and sent them looking for safer investments. The numbers are mind-boggling. More money flowed into U.S. bond mutual funds in 2009 than in the previous 10 years combined. As of June 2010, more money flowed into bond funds than into stock funds for 30 months in a row. So it's not just the heavy hand of the government that is pushing down interest rates; retail investors are playing a role too, by selling stocks and dumping all their cash into bonds (and thus bidding up bond prices).

So everyone is buying bonds, and no one seems to be particularly concerned with the price. Sounds like a bubble, doesn't it?

Why The Bond Market Is Not In A Bubble

The history of bubbles in the investment world dates back hundreds of years. Unfortunately, people seem to be hard-wired, and it is very difficult for us to resist investments that are on the way up. From Dutch tulips in the 1600s to tech stocks in the 1990s to the recent real estate bubble, investors keep getting snookered looking for the next big thing. These bubbles always follow the same path: Prices rise until they reach unsustainable levels, with no underlying logic or connection to fundamental valuation principles. Investors take on debt to buy more and more of the bubble investment. And all kinds of shady characters come out of the woodwork to perpetrate frauds and take advantage of the situation. In the end, the bubble pops. Investors lose massive sums of money and the fraudsters are punished.

The reason the bond market is not in a bubble is that investors can hold their bonds to maturity. Assuming their bonds don't default, investors will recover 100 percent of their principal. In addition, we are not seeing speculative activities as we have seen in other bubbles. (Is anyone taking out a second mortgage to buy Treasury bonds?) Lastly, there's no indication of fraud in the run-up in bond prices - the largest seller of bonds to Americans is the U.S. government.

In a way, this is all semantics. The situation won't be a repeat of the tech stock or real estate bubbles. But there is a lot of money at risk, and reckless investors may end up damaging their financial futures.

Potential Losses For Bond Investors

The most important concept that bond investors need to be familiar with is interest rate risk. As interest rates increase, bond prices decrease. And the longer a bond's maturity period, the more dramatically the price will drop in the event of interest rate increases.

Here is an example of how interest rate risk works. Suppose there are two bonds, both selling at par (100 cents on the dollar). The first bond matures in one year with a yield of 1 percent, and the second bond matures in 30 years with a yield of 3.5 percent. Long-term bonds typically offer higher yields because the investor has to wait longer to recover her principal. If interest rates go up 1 percentage point, both bonds will immediately lose some of their value. The one-year bond will lose about 1 percent of its value. In response to this paper loss, the investor may decide to continue holding the bond until it matures at the end of the year. She will receive her principal back, plus the 1 percent yield.

However, the 30-year bond will lose more value because of its longer maturity. Instead of 1 percent, the bond would lose about 16 percent of its value. The investor can continue to hold the bond until it matures in 30 years, but that will be a long wait. In the meantime, she has a bond worth 84 cents for every dollar she paid, and if she needs to sell her bond to pay for current expenses, she'll have no choice but to realize the loss.

The higher we assume that interest rates go in the next few years, the more staggering the potential losses become. Let's take the same two bonds that we used in our last example, and assume that interest rates go up 5 percentage points. The one-year bond will lose approximately 5 percent of its value. Again, all the investor needs to do is to wait a year, and she will receive her principal plus the 1 percent yield. The 30-year bond loses about 54 percent of its value. And bonds are supposed to be a safe investment!

The most likely scenario in which interest rates will rise is an increase in economic activity, which will lead to a healthy increase in inflation. With inflation currently near all-time lows and investors becoming more and more concerned about deflation, an increase in interest rates could be a very good sign for the global economy. Only bond investors would be hurt in this scenario, while business owners, consumers and stock investors would all be better off.

A Smart Approach To Bond Investing

I hope the previous examples have made clear the danger of purchasing long-term bonds. If you are convinced that we are headed for financial Armageddon, then locking in today's long-term rates is an attractive proposition. But buying today's long-term bonds is a bet that the economy will not recover for the next 10, 20, even 30 years. It is a bet that there will be no inflation in consumer products, medical costs or education. It is a bet that wages will not increase, and neither will rents or real estate values. This is not a bet we are interested in making for our clients.

At Palisades Hudson, we currently focus on short-term, high-quality bonds for our clients' fixed-income allocations. We also invest in bonds such as Treasury Inflation-Protected Securities (TIPS) that, unlike typical fixed-income securities, will appreciate in value as interest rates and inflation increase. While our positioning might sacrifice some yield in the short term, our main objective when investing in fixed-income vehicles is to reduce volatility. We believe that our current fixed-income portfolios accomplish that goal.