The Hot Air Of Bond Bubble Talk

On a recent Google search, I typed in the phrase “bond bubble,” and was presented with 25.8 million results. As continues to be the case, the media, pundits, and other fixed-income “watchers,” seem convinced that an imminent disaster is about to strike the bond market. But this is really nothing new. Soon after the financial crisis dissipated in 2009, a steady, and frequent, flow of commentary has flooded investors’ ears on the subject. But with rates flat to slightly lower over the past five years, omnipresent alarms have proven nothing but false. As I write this article, the 10-Year Treasury is down to 2.34%, after scraping 3% earlier in the year.

bond bubble

The latest piece of fear mongering, published by Marketwatch.com and titled, “Beware The Enormous Bubble In Bonds,” had as its major tenets: “Rising bond issuance, sinking prospects, and falling yields — an unnatural trio of circumstances that only a bubble-blowing central banker could cheer.”

  To see a list of high yielding CDs go here.  

Let’s talk about the second and third points first, sinking prospects/falling yields. If we take a long-term, 30-year perspective on the bond market, I certainly agree with the author. There is not a lot of upside today to investing in bonds as compared to yesteryear. Rates do not have much further to fall from already depressed levels, which makes both the instant yield gratification and total return potential of both short- and long-term paper arguably mediocre.

Still, one of the popular trade ideas at the beginning of 2014 was a short of long-term bonds. But with the drop in Treasury yields, that trade has now lost 20 percent. Indeed if one had instead invested in a long-term ETF such as TLT, they’d be sitting on a 15% gain.

TLT – YTD

bond bubble

Source: Marketwatch.com

So bond traders willing to wade into the riskier milieu of longer-term paper have made a lot of money on the long side by betting on near-term rates. So much for a bubble.

Most passive investors are looking at bonds for their cash flow characteristics, however, and making predictions on near-term interest rate gyrations is not their game. But if you had heeded the prevalent “bubble” advice for the past five years, you’d be sitting on cash earning nothing, while bonds have by and large earned their coupon, plus some capital upside, depending on their duration.

The other point the article made was that of “rising bond issuance.” Logic would dictate that as rates fall and money becomes cheaper, borrowing will rise. Of course if government entities, corporations, families, or whomever over leverage themselves, this could become problematic if rates rise and there is forced refinancing. Higher cost of capital could lead to tax hikes, and reduced earnings – depending on the entity we are looking at. In worse-case scenarios rampant interest rate rises could lead to bankruptcies in over-levered entities.

While rising leverage is certainly something on a macro-level to keep an eye on, for the conservative bond investor, it may be much ado about nothing. Though A-rated organizations may take a profit hit if their cost of capital rises, bond investors are really only concerned with the organization’s ability to pay periodic interest and repay capital at maturity.

If the earnings/stock price of an investment-grade company in a bond portfolio slumps, there’s really nothing to initially worry about. Of course if the company’s situation worsens and its credit rating drops below investment grade, then you may have to take a closer look at your bond.

Unless you are willing to take calculated timing chances on the bond market, the best strategy may be to try to find the sweet spot of both credit and duration to maximize risk-adjusted yield. I’m finding that to be in the BBB/BB range with maturity in 7-10 years. Delving in to high-yield (BB) is not appropriate for everyone however. If your risk tolerance is low, it may be best to stick with ‘A’ rated paper, even if that means sacrificing yield.

To conclude, most pundits seem to be discounting the possibility that interest rates remain low for the foreseeable future. While I personally am not willing to predict that rates won’t go higher at some point – unlike others who seem keen on continuing to blast bonds – I admit I have no idea when that may be. I suspect “bond bubble” articles will continue to persist until bears give up or consider themselves right in the matter. That may be in six months…. but investors should keep an open mind to thinking that it may be, well, never.

About the author:

aloisiAdam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.

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