Are Bonds Really in a Bubble?

Sep 2012

Outside of Europe’s well-publicized financial woes, the topic receiving lots of attention these days is the oncoming bond market bubble.  The financial news media is doing their best to identify asset bubbles before they occur, but I’m not so sure they have been effective, especially for bonds.  Of course, they (and most economists) missed the previous two worst bubbles in recent memory—internet stocks and real estate—so it makes sense they want to try and find the “next” bubble to gain readers/subscribers. But, are bonds really in a bubble?

First, what is a bubble? The way I define a “bubble” is a continual rise in the price of an asset with horrible looking valuations and fundamentals.  I would also add to that rampant speculation like high volume option trading and leverage (i.e., borrowing to purchase stocks).  Using my definition, it is difficult to see how bonds are in a bubble.  Technology stocks, which drove the stock market to all-time highs in the mid to late 1990’s, were perhaps the most well-known bubble because there was excessive speculation and outrageous valuations, especially for Internet-related stocks.  The same could be true about residential real estate right before the 2008 financial crisis.

Yes, bond values have risen dramatically over the past few years mostly due to Federal Reserve monetary policy and stock market aversion.  Yes, investors have been adding billions to bond mutual funds over the past three years despite a 100% rise in the S & P 500 Index over that same period.  The second point is interesting because it shows that investors have been investing in bonds and bond mutual funds because they are nervous about the stock market.  They have been burned over the past ten years and are fed up with the seemingly endless ups and downs.  In other words, bonds have gone up because people are fearful of stock market declines and extreme volatility, not because people believe bonds are going to produce stock-like returns over the next 10 years.  That behavior does not a bubble make.  It makes for irrational and faulty logic, but doesn’t define a bubble in the technical sense.

You could infer that the massive inflows to bond funds is a result of asset allocation decisions, i.e., baby boomers lowering their risk appetites as they approach retirement, but this runs counter to a stock market that has performed very well since March 2009.  In normal times, you would see stock fund inflows substantially outgain bond fund inflows.  That has not happened in more than five years.  Market fears have trumped stock market performance.  Why this is occurring at a time when people need growth is puzzling.

As the chart above from Investech Research shows, 30 Year U.S. Treasury Bond yields have dropped for the past 30 years. More recently, they’ve dropped even further due to fears of another slowdown, and Europe.  Eventually, interest rates will have to rise, but it’s anybody’s guess as to when they will go up.  Even if rates do go up, that doesn’t necessarily mean all bonds will drop substantially.  The Fed has already indicated it will telegraph their intentions as effectively as possible to help cushion the eventual rise in rates.  This will hopefully help bond investors plan for changes before any real damage is done.

Below are immediate actions investors should consider taking to help mitigate the eventual rise in interest rates:

Diversify your bond holdings.  Your bond mix should include more than just Treasury bonds.  Long-term Treasury bonds (those with maturities greater than 10 years) will get hurt the most when rates eventually go up.  You may want to consider adding corporates, Treasury-inflation protected, mortgages, global/foreign, and municipals, where feasible.  Not all bond types will react to rising interest rates the same way.

– Shorten up your bond maturities.  If you are using mostly bond mutual funds and/or ETFs, then find those with shorter average maturities.  If you use mostly individual bonds, then consider using a ladder strategy (purchase bonds of differing maturities so that the average maturity is 5 years or less).

Use cash/money market funds.  If interest rates begin climbing, and if and when the Federal Reserve raises shorter-term interest rates, money market account yields will go up, making them more attractive.  The good think about money markets is, when rates go up, you don’t lose money.

In the end, a long-term diversified investment portfolio should continue to have exposure to bonds and/or money market accounts to help control volatility and smooth out returns so please think twice before selling all of your bonds and/or bond mutual funds because of bubble-based articles that have weak context supporting their views.

-Jack K. Riashi, Jr., CFP ®

Financial Advisor

Bloom Asset Management


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