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  • Bond Bubble?

    Posted by Carl from Chicago on June 12th, 2010 (All posts by )

    A recent Wall Street Journal article titled “Bond Fund Managers See Signs of A Bubble” discusses the state of the bond market and large inflows into bond mutual funds by investors seeking returns and attempting the avoid the risk that they see in the stock market.

    A key element to understanding this or any other analysis on bonds is the difference between holding an individual bond to maturity vs. buying a fund that invests in bonds. They behave very differently. If you buy an individual bond and hold it for its life, unless that company goes bankrupt or has some sort of liquidity event, you will receive back your principal at some point in the future and interest payments along the way. Unless you are unlucky and it goes into default, it is a predictable stream of payments. Bond funds, on the other hand, invest in a whole range of individual bonds and do not necessarily hold them to maturity. Bond funds are significantly impacted by interest rates; when interest rates RISE, the value of their bond holdings immediately falls and investors receive losses. If interest rates FALL, investors in bond mutual funds receive gains. Thus holding individual bonds, once purchased, is mostly about default risk for that particular issue, while investing in bond mutual funds is primarily about the direction of interest rates and also overall default risks across all issues.

    This situation is summarized as such in the article:

    Interest rates will likely rise in coming years from a base of almost zero today. But investors mostly only know what they have seen in the past 25 years, which for the most part has been period of steadily declining interest rates and rising bond prices.

    There isn’t any “up side” to bond mutual funds right now, from an interest rate perspective, because rates are almost at zero. If rates are going to change they are going up. In addition, low interest rates means less pressure on entities that require debt financing, and rising interest rates will not only slam bond fund values but they will increase the default risk on bonds in the fund as those entities must pay a higher price to refinance future needs.

    Compounding the problem is that many investors don’t remember when bond funds did lose money for a prolonged period.

    The stagnant stock market over the last decade or so, as measured by the major indexes, along with terrifying swings in-between, is pushing individuals away from the stock market. I remember when I first (naively) started investing in the early 1990s in my 401(k) and telling my peers that they were crazy not to be 100% in stocks, especially since it was a long way to retirement. While I am still in the stock market today, I would never give that sort of advice now and I believe that the guidance that you should be heavily invested in stocks when you are younger often goes too far when the % of stocks in portfolio climbs above 75% or so.

    The same types of “herd” thinking are working in reverse for the bond funds. Since they have only MADE money over the last 20 or so years, they are viewed as low risk, when really a huge portion of that gain is due to our policies favoring low interest rates which results in gains for bond funds and also lowers default risk. As these forces turn around when interest rates go up, many individuals are likely to be surprised by the impact to their portfolio of remaining heavily invested in bond mutual funds.

    While bonds may have issues, it doesn’t mean that you have to pile back into the stock market. Bond mutual funds are often used as a (sloppy) proxy for “safe” investing, which earns a return but doesn’t put much principal at risk. You can achieve that same goal with safer debt instruments such as certificates of deposit or short-term treasuries. If you are in a bond mutual fund you should not view that money as “safe” – you should view it substantially at risk should interest rates go up or if default rates pick up significantly.

    Cross posted at Trust Funds for Kids and LITGM

     

    5 Responses to “Bond Bubble?”

    1. Paul Milenkovic Says:

      What do people think about TIPS (Treasury Inflation-Protected Security) bond funds?

      One way is to own the actual TIPS bonds from the US Treasury, but the funds have all of the advantages of funds for small investors with respect to minimum investment amount and “safekeeping” fees for actually owning the Treasury instruments.

      The TIPS bonds are paying less than the next-to-nothing of ordinary Treasuries and other bonds, but, they are supposed to increase their interest payout if inflation kicks in, presuming that the powers that be don’t game the system that the official indices of inflation manage to understate what is happening to prices in the economy.

      I am thinking TIPS bonds or bond funds or perhaps the Series I Savings Bonds are as good as owning gold in terms of inflation hedging. If it comes to a US Treasury default on the TIPS bonds, I don’t think your gold is going to do much either, and one should have invested in canned food and ammo to hunt squirrels for the table.

      Am I on track with this or am I missing something?

    2. Jonathan Says:

      The bond mkt is being propped up by our govt’s zero-interest-rate policy. It’s all about the carry trade now. Banks borrow at 0% from the Fed — i.e., the taxpayers — and buy bonds yielding 2-3%. (There’s no longer any need to lend money to productive businesses.) Individuals park their cash in bond funds because stocks are volatile and there’s nowhere else to invest without substantial risk. This is unsustainable and it’s all going to blow up eventually.

      TIPS won’t protect you, or not completely. Their interest rate is based on an index that may be inaccurate or corrupt, and — the big problem — doesn’t account for inflationary expectations. Eventually there’s probably going to be either a sudden large increase in inflationary expectations or a break in the bond mkt (chicken/egg). Either event will instantly boost the cost of govt borrowing and make further interest-rate increases and bond-price declines even more likely. At some point the process becomes self-reinforcing and there is a crisis. It could happen in one day. It isn’t certain that this will happen, but it will probably happen eventually if we don’t control our govt’s spending and borrowing. The Obama administration and Congress are betting that it won’t happen on their watch. Maybe they are right but I wouldn’t bet on it.

    3. emerich Says:

      I think you’re more likely right than wrong that there isn’t any upside to owning a bond fund, but you’re certainly wrong that ”

      “There isn’t any “up side” to bond mutual funds right now, from an interest rate perspective, because rates are almost at zero”

      Fed funds and short term treasurys are “almost at zero” but long-term instrument aren’t. The 10-year treasury is around 3.3%, which is not zero. Bond funds will be unprofitable only if realized future short-term rates rise more than those implied in today’s yield curve. It’s certainly a defensible argument that short-term rates will rise more than implied by the yield curve, but the argument would be different from saying rates have to rise “because they’re zero now.”

    4. Carl from Chicago Says:

      Agreed that I was simplifying the argument on interest rates but, in general, there has been a phenomenal and as Jonathan pointed out, unsustainable set of policies that drove this bull market in bonds and it is likely to come to an end at some point (big downside) with little upside.

      This isn’t to say that you can’t be in fixed income or that you have to go back to the stock market but I stand by my general theme that the average guy doesn’t understand the risks of piling into bond mutual funds in particular right now.

    5. Michael Kennedy Says:

      I can remember buying ten year Treasuries, with a coupon rate of 16%, at a discount about 1980 for my pension plan. I really hated it when those bonds finally cashed out at term. The yield based on purchase price was 18%. Few people investing today have seen this. It will come back, in my opinion, and not that far in the future. I hope I am wrong but I am preparing for it.