Understanding the ‘Bond Bubble’

Perhaps the most often question that I am asked of late is how does one protect him/herself from the pending burst of the bond bubble? It is a difficult question to answer as it depends on one’s perspective and what they are really trying to protect themselves from. Moreover, I am not even sure that a true bubble exists yet I understand why these questions are being raised. So, let me give it my best shot.

First, I would define a bubble as a surge in the price of a particular asset to levels far greater than its perceived intrinsic value. Extreme examples include the price of tulips during the Tulip Mania of 1636-1637, the rise of technology stocks in 1999 and peaking in March of 2000, and real estate in 2007. In these instances, speculators drove the price of these assets to record highs. Yet, when sentiment changed, the price for tulip bulbs, dot.com tech stocks and residential real estate valuations in many communities fell precipitously. If measured from peak to trough, it would not be unusual to see prices fall by 50%, if not much more.

So, when I see or hear the word “bubble”, I immediately think about these past experiences. Yet, I do not believe bond prices, in most instances, are trading at similarly peak valuations and subsequently, vulnerable to a similar decline in value. A mutual fund consisting of very long-dated, zero-coupon bonds, as an extreme example, would be very vulnerable to rising interest rates and might be put into this bubble category. However, the typical bond portfolios that we manage at Sigma are vastly different and this is the basis of my analysis.

What I do accept is that we are in an environment where the yield curve is trading near historic lows and it would be reasonable to assume that over the next two or three years, if not much sooner, rates will be higher than where they are today. If I am correct, we will be entering a period where the total return on many bond portfolios may generate a low single-digit return at best and a moderately negative return at worse during a similar peak to trough period, but nothing similar to the 50% or greater declines often associated with the bursting of a bubble with other asset classes.

For example, let’s assume that an individual owns a 10-year laddered bond portfolio with a modified duration of 7 years and a yield to maturity of 2.5%. If the yield curve jumped by 1% overnight and all else being equal, the value of the portfolio may decline by approximately 7% overnight to readjust to the new yield curve. But if these bonds were held to maturity, the investor would not lose money on his/her original investment. Yet, over a 10-year period, there may be a few years of negative returns but the cumulative return over 10 years should be positive. Moreover, as interest rates rise, the maturing bonds and interest income can be re-invested to earn an increasingly higher rate of return, possibly enhancing the total return of the portfolio over time.

Understandably, most investors are not very keen about losing value in their bond portfolios, even if the negative returns are manageable and short-lived. So, the options are to lock in values and go to cash, accepting a negligible return for a while until the yield curve goes back to normal. The problem here is that this could take years before yields stop rising and the opportunity loss in return is likely far greater than the temporary economic loss that one would be avoiding staying in cash. Also, does anyone really know when to jump back in? Probably not.

Alternatively, one can seek to sell out of bonds and go into other asset classes. The challenge here is that any alternative asset class is likely to have greater downside risk, negating why you were making the change to begin with.

Given the lack of suitable alternative options, Sigma recommends a thoughtful determination of one’s appropriate asset allocation and thus, how much should be invested in fixed income securities (bonds). Accept the fact that yields are low at this time, but know that rates will rise over time. During the interim, keep the duration of the portfolio fairly short-term. (Three to seven years would be a good range to shoot for in most situations.) Introduce a small amount of TIPS (Treasury Inflation Protected Securities) into the portfolio as a hedge against hyperinflation, and allow for a small amount of high yield bonds to capture the above average yield that they provide.

As always, we invite your questions and comments.

Christopher J. Kress, CFA