Bond Bubble: What Is It? The Pros And The Cons

We’ve all heard of the NBA Bubble, the Bubble Boy from Seinfeld but what is the new “bubble” in the bond market? You might have heard about it in the media or through online financial articles! However, learning what the bond bubble means can actually bring changes to your investment portfolio – so this might be something you want to check out. 

Bond Bubble: Everything You Need To Know

What Is a Bond Bubble?

  • There was ongoing talk of a “bond bubble” in an article written by noted finance professor Jeremy Siegel of the Wharton School at the University of Pennsylvania. He called it “The Great American Bond Bubble”. This was an environment where bonds were considered as artificially high, although actual returns didn’t seem to support this.
  • Now to understand this let’s see how a bubble is created. It happens when an asset, such as a bond or stock, trades far above its actual worth for an extended period of time. The inflated prices are regularly fueled by investor greed and the ubiquitous belief that no matter how high prices might be now, someone else is likely to pay an even higher price in the near future – gets us into trouble. Eventually, bubbles end. The cost of the asset will decline to something more like a realistic value which could lead to heavy losses for those investors who were late to the party. 
  • It would be best to explain further using the past as an example. Bubbles have indeed existed throughout the history of mankind. Let’s think of bubbles in the cost or pricing of other assets throughout history like the Dutch tulip bulb mania incident. The Dutch tulip bulb mania occurred during the 1630s and but other examples followed like the shares of the South Sea Company in Great Britain in 1720, railroad stocks in the United States of America in the 1840s, the U.S. stock market run-up in the 1902s, and Japanese stocks and real estate market in the 1980s.
  • But if we were to draw the curtains of the past and look at more recent events, it happened right in front of our faces during the famous American bubbles in technology stocks in 2000 and 2001 and in real estate in the mid-2000s. Each of these bubbles came crashing down with a force in the price of each asset question, and—for larger bubbles such as those in Japan in the 80s and in the United States in the past decade—an extended period of economic weakness.

Identify and Learn When It’s Really a Bond Bubble (Mistakes Have Happened)

  • The financial media mainstream is booming and lots of people have lots of benefits to yell “Bubble!” and relish the media attention that it brings. But it’s a good habit to always question what you hear, and the financial news about the existence of a bond bubble in 2018 is a really great example. During March of 2018, word began spreading that the rising, or bull market in bond prices, was about to come to a sudden standstill. At the time, bond yields had risen to just shy of 3 percent in the early half of the year, and in some peoples’ minds, a burst was about to happen at any point. 
  • Just 2 months later, in May 2018, the bond prices that were considered a “bubble” were still intact, at least with respect to the corporate bonds that were the main focal point of this talk. But the particular cost level for corporate bonds that was being called a bond bubble had been intact and in place since 1981. Meanwhile, the risk-free 10-year treasury bond had shot up by 172 basis points after July 2016.
  • Comparing this with another 2 months down the line, in July 2018, publicly-quoted financial experts continued to preach that the bull market of increasing prices was starting to weaken, again referring mostly to corporate bonds, and implied that a bubble occurred and that it was about to burst.

If the Bubble Is Real, Will It Burst?

Investors should give careful consideration to the two factors that are listed below. Despite the knowledge that it’s almost certain that Treasury yields will be higher in the future than they are today, you still need to consider the following: 

First, look at the increase in yields—if it occurs—the probability is to occur over an extended period of time. It most likely won’t happen in short, explosive movements such as the bursting of the dot.com bubble.

Secondly, look at the history of Japan’s bond market. It can provide some pause for the many pundits who have a negative outlook on the U.S. Treasuries. A closer inspection in Japanese history shows a similar story to what occurred  in the United States several years ago: A financial crisis brought about by a crash in the property market, was then linked to an extended period of slow growth and a central bank policy featuring near-zero interest rates and subsequent quantitative easing. The 10-year bond yield dropped below 2 percent. Japan felt these events in the 1990s. The drop in Japan’s 10-year below 2 percent occurred in late 1997 and it hasn’t re-established this level for more than a brief interval since then.

According to one article “Bonds: Born to Be Mild” on the commentary website SeekingAlpha, AllianceBernstein the fixed-income chief Douglas J. Peebles stated: “Increased bond buying by insurance companies and private-sector defined-benefit plans could also temper the pace at which bond yields rise.” 

What this means is that higher yield would drive renewed demand for bonds, moderating the impact of any sell-off. Even if the U.S. bond market eventually collapses as many are predicting, it is not likely if the post-crisis experience in Japan, which has been very similar to ours thus far, is any indication. In essence, the indication is that rates can remain low much longer than investors are expecting.

What Factors Contribute to a Bond Market Bubble?

The financial media has continued to predict the U.S. bond market as the next great asset bubble since the year 2013. The idea behind this forecasting is relatively simple: The yields on the U.S. Treasurys dipped so low in 2010 or so that there was little room for further decline. We should also remember that prices and yields move in opposite directions.

A key reason behind such low yields was the policy of the ultra-low short-term interest rates the Federal Reserve enacted to promote growth. Whenever the economy recovers and employment increases to more normalized levels, the Fed starts to raise interest rates. When this happens, the artificial downward pressure on Treasury yields is non existent and the yields climb back up as prices fall.

It could be said that Treasury bonds are most definitely in a bubble—not necessarily because of any investor mania as was the case in past bubbles, but because Treasury yields are larger than they would be without the Fed’s intervention to keep rates low.

Why Is the Bond Bubble More Important Than Previous Bubbles?

Fixed income’s traditional position within asset allocation is considered as a “safe investment“. In fact, we have entered one of those rare times in history where the risk/reward analysis on bonds could conceivably be more dangerous than equities, this is because the historically low coupon points towards historically unprecedented volatility and downside price risk.

In other words, capital loss risk to bonds is the maximum when starting yields are lowest. Considering that yields are at an all-time historical low, many historical benchmarks for capital losses in bonds are unrealistically conservative. What lies beyond us could easily be far worse than in the past. For example, according to Welton Investment Corporation, the deepest (-15.3%) and longest (8+ years) Aaa corporate bond drawdown occurred between 1954-1963 because of a tiny 1.8% increase in interest rates – this would be considered just a hiccup by today’s volatile standards. The reason is that the starting yield in 1954 was an equally tiny 2.85%.

What this means is that the drawdown severity and duration aren’t calculated only by the magnitude of the interest rate rise. It’s calculated by the relationship of the interest rate increase compared to the starting yield. Today’s record low yields imply a historically high risk of capital loss. For example, Welton also analyzed what could happen to Aaa corporate bonds under varying interest rate increase scenarios:

A 6% increase spread over 5 years would result in a 36.2% drawdown and a 6.4% annual loss.

A 4% increase in just 1 year would lead to a whopping 34.8% drawdown and a 34.8% annual loss.

Even a modest increase spread over many years could result in zero return (or worse) for more than a decade.

These losses may not look nasty by equity market standards, but it’s important to keep in mind that the money parked in top quality bonds is considered “low or no risk”. That is clearly no longer what’s happening and it has serious implications for traditional asset allocation models.

Some can debate that if you hold the bonds to maturity then price risk is only a temporary problem, but that’s a dangerous half-truth. Today’s investors frequently hold their bonds in diversified pools of mutual funds and ETFs, giving up any ability to ride out the downturn and hold a particular bond to maturity. The losses can become permanent. Funds in top quality bonds are no longer ‘low or no risk’ – traditional asset allocation models are unprotected. 

Bond Bubble Limitations

Considering the unfavorable risk/reward ratio, as an investor, what should you do? To answer that, we must look at many factors including your investment goals, time horizon, specific portfolio composition (duration, quality, etc.) and how much interest rates actually rise.

What we do know is over time, investors will demand greater returns to accept the risk that comes with lending their money. As nations grow increasingly in debt, how many more short-term fiscal manipulations can be taken into consideration to keep interest rates artificially low? Most people don’t know but we do that a turn of the tide in interest rates is merely a question of when – not if. 

The bubble could continue for years before turning, but that doesn’t change the mathematical reality that it’s clearly a bubble — risk to reward analysis doesn’t make a lot of economic sense. For example, do you think you could lend to the government of the U.S for 5 years for an 88 basis point return? No one should risk substantial downside losses for a maximum potential upside gain close to zero (or worse) net of inflation.

What Does Longer-term Data Show For the Rarity of Major Sell-Offs?

Looking at the past shows that the downside in Treasuries has been relatively limited. According to data compiled by an individual called Aswath Damodaran at New York University’s Stern School of Business says that the 30-year bond has suffered a negative return in only 15 calendar years since the year 1928.

In general, the losses were relatively limited. Keep in mind, however, that yields were increasing in the past than they have been recently so it took much more of a price decline to offset the yield in the past than it would today.

While the previous statistic isn’t an indicator of future results, it does help illustrate the rarity of a large collapse in the bond market. If the bond market does in fact fall upon hard times, a more likely result is that we’ll see consecutive years of sub-par performance, similar to what occurred in the 1950s.

What About Non-Treasury Segments of the Market?

We’ve spoken a lot about treasuries in this article but they aren’t the only market segment said to be in a bubble. As noted, similar claims have been discussed about corporate and high yield bonds, which are valued based on their yield spread compared to Treasuries.

Not only have these spreads drastically reduced to historically low levels in response to investors’ growing appetite for risk, but the extremely low yields on Treasuries help us conclude that the absolute yields in these sectors have decreased close to all-time lows. In all cases, the reason for the “bubble” concerns is the same: Cash flowed into these asset classes amid investors’ ongoing thirst for yield that happens to shoot up prices to unreasonably high levels.

Does this indicate bubble conditions? Not necessarily. While it most definitely indicates that the future returns of these asset classes are likely to be less robust in coming years, the odds of a major sell-off in any type of calendar year is relatively low if history is any indication.

High yield bonds resulted in negative returns in only four years since 1980, as gauged by the JP Morgan High Yield Index. Even though one of these downturns was huge—a 27 percent drop during the 2008 financial crisis—the others were relatively modest: -6 percent in 1990, -2 percent in 1994, and -6 percent in 2000.

The Barclays Aggregate U.S. Bond Index uses Treasuries, corporates, and other investment-grade U.S. bonds. It has helped gain ground in 32 of a period of the past 38 years. The one down year was 1994 when it dropped by 2.92 percent.

Although they can be frightening at the time, these downturns have historically been seen as manageable for long-term investors. It usually isn’t long before the markets rebound and players are able to recover their losses.

Final Verdict For The Bond Market Bubble

The wisest choice In almost every situation when it comes to investing is to stay the course as long as your investments continue to meet your risk tolerance and long-term goals. If you keep on pursuing in bonds for diversification, stability, or to boost your portfolio’s income, they can keep going on to serve this role even if the market encounters some turbulence.

A wiser plan of action might be to temper your return expectations after a strong run of years. Instead of expecting a continuation of the stellar returns the market experienced during other intervals, you as a player would be wise to plan for much more modest results going forward.

Of course, the only exception to this would be someone who is in or near retirement or who needs to use the money within a one- to two-year period. It doesn’t pay to take the undue risk no matter what situations are in the broader market when a player in the market needs to use the money soon.

Please keep in mind that the information on this site is provided for information purposes only, and should not be construed as investment advice. These tips and opinions are not given to represent a recommendation to buy or sell securities. Make sure that you consult an investment and tax professional before you choose to invest. 

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