The Bond Market Bubble: Fact or Fiction?

There has been ongoing talk of a "bubble" in the bond market, which has been documented in the media, such as in an article written by noted finance professor Jeremy Siegel of the Wharton School at the University of Pennsylvania.

"The Great American Bond Bubble" described an environment where bonds were thought to be artificially high, although actual returns didn't seem to support this. Talk of a bubble comes in and out of the media, which can cause unrest among investors who are concerned about their portfolios.

Understanding more about a bond bubble can help you consider whether you need to make any changes to your investment portfolio.

What Is a Bond Bubble?

A bubble is created when an asset—such as a bond or stock—trades far above its true worth for an extended period of time. The inflated prices are often fueled by investor greed and the widespread belief that no matter how high prices might be now, someone else is likely to pay an even higher price in the near future.

Eventually, bubbles end. The price of the asset will decline to something of a more realistic value, which could lead to heavy losses for investors who were late to the party.

Bubbles Throughout History

To explain price bubbles in more depth, consider bubbles in the price of other assets throughout history. For example, there was the Dutch tulip bulb mania during the 1630s, the shares of the South Sea Company in Great Britain in 1720, railroad stocks in the United States in the 1840s, the U.S. stock market run-up in the Roaring Twenties, and Japanese stocks and real estate in the 1980s.

More recently, the U.S. experienced bubbles in technology stocks in 2000 and 2001 and in real estate in the mid-2000s. Each of these bubbles ended with a crash in the price of each asset in question and—for larger bubbles such as those in Japan in the 80s and in the United States in the past decades—a protracted period of economic weakness.

Understanding When It's Really a Bubble

Many people in the financial media mainstream have plenty of incentive to scream "Bubble!" and enjoy the media coverage that follows. But it's a good idea to question what you hear, and the financial news about the existence of a bond bubble in 2018 is a good example.

Word began spreading in March 2018 that the rising—or bull market—in bond prices was about to come to a screeching halt. At the time, bond yields had risen to just shy of 3% at the beginning of the year, and in some peoples' minds, a burst was imminent.

Two months later, in May 2018, the bond prices that were deemed a "bubble" were still intact, at least with regard to the corporate bonds that were the main focal point of all the talk. But the particular price level for corporate bonds that was being called a bond bubble had been intact and hanging in there since 1981. Meanwhile, the risk-free 10-year Treasury bond had increased by 172 basis points since July 2016.

Two more months later, in July 2018, publicly-quoted financial experts continued to prophesize that the bull market of rising prices was starting to weaken—again referring mainly to corporate bonds—and implied that a bubble existed and that it was about to burst.

Contributing Factors to a Bond Market Bubble

The financial media has continued to forecast the U.S. bond market as the next great asset bubble since 2013. The idea behind this is relatively simple: The yields on U.S. Treasurys dropped so low around 2010 that there was little room for further decline. Keep in mind 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 stimulate growth. Whenever the economy recovers and employment rises to more normalized levels, the Fed begins to raise interest rates. When this happens, the artificial downward pressure on Treasury yields is removed, and the yields rise back up as prices fall.

If the Bubble Is Real, Will It Burst?

The conventional wisdom is that it's almost certain that Treasury yields will be higher in the future than they are today. That's indeed the most likely scenario, but investors should give careful consideration to two factors.

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

Second, the history of Japan's bond market can provide some pause for the many pundits who have a negative outlook on U.S. Treasuries. A look at Japan shows a similar story to what occurred here in the United States several years ago: A financial crisis brought about by a crash in the property market, followed by 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%. Japan experienced these events in the 1990s. The drop in Japan's 10-year below 2% occurred in late 1997, and it hasn't regained this level for more than a brief interval since then.

In the article "Bonds: Born to Be Mild" on the investing commentary website SeekingAlpha, AllianceBernstein fixed-income chief Douglas J. Peebles noted:

"Increased bond-buying by insurance companies and private-sector defined-benefit plans could also temper the pace at which bond yields rise."

In other words, a higher yield would drive renewed demand for bonds, moderating the impact of any sell-off.

Could the U.S. bond market eventually collapse as many are predicting? Possibly, but not likely, if the post-crisis experience in Japan, which has been very similar to ours thus far, is any indication that rates can remain low—for far longer than investors are expecting.

Longer-Term Data Shows the Rarity of Major Sell-Offs

A look further back shows that the downside in Treasuries has been relatively limited. According to data compiled by Aswath Damodaran at New York University's Stern School of Business, the 30-year bond has suffered a negative return in only 15 calendar years since 1928.

In general, the losses were relatively limited. Keep in mind, however, that yields were higher 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 past performance isn't an indicator of future results, it does help illustrate the rarity of a major collapse in the bond market. If the bond market does indeed fall upon hard times, a more likely outcome is that we'll see consecutive years of sub-par performance, such as what occurred in the 1950s.

Non-Treasury Segments of the Market

Treasuries aren't the only market segment said to be in a bubble. Similar claims have been made about corporate and high yield bonds, which are valued based on their yield spread relative to Treasuries.

Not only have these spreads shrunk to historically low levels in response to investors' growing appetite for risk, but the ultra-low yields on Treasuries mean that the absolute yields in these sectors have fallen close to all-time lows. In all cases, the case for the "bubble" concerns is the same: Cash poured into these asset classes amid investors' ongoing thirst for yield tends to drive prices to unreasonably high levels.

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

Positive and Negative Returns

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

The Barclays Aggregate U.S. Bond Index incorporates Treasuries, corporates, and other investment-grade U.S. bonds. It has gained ground in 32 of the past 38 years. The one down year was 1994 when it shed 2.92%.

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

Weathering a Bond Market Bubble

In almost every situation, the wisest choice in investing is to stay the course as long as your investments continue to meet your risk tolerance and long-term objectives. If you invested in bonds for diversification, stability, or to boost your portfolio's income, they can continue to serve this role even if the market encounters some turbulence.

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

The main 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 undue risk, no matter what conditions are in the broader market when an investor needs to use the money soon.

Disclaimer: The information on this site is provided for discussion purposes only and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Be sure to consult investment and tax professionals before you invest.