During the final months of 2012, the talk of a “bubble” in the bond market grew to roar – and so far this year, nothing has changed. Following a 32-year bull market in Treasuries and several years of strong outperformance for corporate, high yield, and emerging market bonds, the number of commentators proclaiming that bonds are a bubble set to burst has increased exponentially.
This may leave investors wondering what a bubble is, what the basis is for this claim, and what a bursting bubble may mean for their portfolios. Below, we seek to answer each of these questions in turn.
What is an Asset Bubble?
A bubble is simply a case of an asset that trades far above its true worth for an extended period of time. Typically, the run-up in prices if fueled by rampant investor greed and the widespread belied that no matter how high prices may be now, someone else is likely pay an even higher price in the near future. Eventually, bubbles end with the price of the asset declining to a more realistic value, leading to heavy losses for investors who were late to the party.
There have been numerous bubbles throughout history, including the Dutch tulip bulb mania (1630s), the shares of the South Sea Company in Great Britain (1720), railroad stocks in the United States (1840s), the U.S. stock market run-up in the Roaring Twenties, and Japanese stocks and real estate in the 1980s. More recently, the United States experienced bubbles in both technology stocks (2000-2001) and real estate (the mid 2000s). All, of course, ended in a crash in the price of each asset question, and – for larger bubbles such as those in Japan in the 80s and in the United States in the past decade – a protracted period of economic weakness.
Why Would the Bond Market be in a Bubble?
If you believe what you read in the financial media, the U.S. bond market is the next great asset bubble. The thesis behind this is relatively simple: following the historic bull market, U.S. Treasury yields have dropped so low that there is little latitude for further decline. (Keep in mind, prices and yields move in opposite directions.) What’s more, a key reason that yields are so low is the policy of ultra-low short-term interest rates the Federal Reserve has enacted in order to stimulate growth. Once the economy fully recovers and employment rises to more normalized levels, the thinking goes, the Fed will begin to raise rates. And when this finally occurs, the artificial downward pressure on Treasury yields will be removed, and yields will rise sharply (as prices fall).
In this sense, it could be said that Treasuries are indeed in a bubble – not necessarily because of a mania as was the case in past bubbles, but because yields in the marketplace are higher than they would be without the Fed’s aggressive action.
Does this Mean the Bubble Will Burst?
The conventional wisdom is that it’s almost certain that Treasury yields will be higher three to five years from now than they are today. That is indeed the most likely scenario given that the Fed is indeed going to have to alter its approach at some point, but investors need to give careful consideration to two factors.
First, the increase in yields – if it occurs – is likely to occur over an extended period of time, rather than in a short, explosive move such as the bursting of the dot.com bubble.
Second, the history of Japan's bond market may 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: 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. And, as is the case in the United States today, the 10-year bond yield dropped below 2%. Unlike the United States, however - where all of this has occurred in the past four-plus years - Japan experienced these events 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. As of spring 2013, it continues to offer a yield below 1% - just as it did 15 years ago.
Also, in an article title "Bonds: Born to Be Mild" on the commentary website SeekingAlpha.com, 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, 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? Perhaps. But the post-crisis experience in Japan - which has been very similar to ours thus far - indicates that rates can remain low far longer than investors are expecting.
Longer-Term Data Shows the Rarity of Major Sell-Offs in Bonds
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 of 84 calendar years since 1928. In general, the losses were relatively limited, as shown in the table below. Keep in mind, however, that yields were higher in the past than they are now, so it took much more of a price decline to offset the yield in the past than it would today. All returns incorporate both yield and price return:
- 1931: -2.56%
- 1941: -2.02%
- 1951: -0.30%
- 1955: -1.34%
- 1956: -2.26%
- 1958: -2.10%
- 1959: -2.65%
- 1967: -1.58%
- 1969: -5.01%
- 1978: -0.78%
- 1980: -2.99%
- 1987: -4.96%
- 1994: -8.04%
- 1999: -8.25%
- 2009: -11.12%
While past performance isn’t an indicator of future results, this helps 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 several consecutive years of sub-par performance, such as what occurred in the 1950s.
What About the non-Treasury Segments of the Market?
Treasuries aren’t the only market segment said to be in a bubble. During the latter part of 2012, similar claims were made in regard to corporate, high yield, and emerging market bonds. All three groups are valued based on their yield spread relative to Treasuries. Not only did these spreads shrink in response to investors’ growing appetite for risk, but the ultra-low yields on Treasuries mean that the absolute yields in these sectors fell to, or close to, all time lows. In all cases, the case for the “bubble” concerns was the same: cash poured into these asset classes amid investors’ ongoing thirst for yield, driving prices to unreasonably high levels.
Indeed, returns in the 2010-2012 interval were nothing short of spectacular. Investment-grade corporate bonds averaged annual returns of 8.9% in the three-year period, while long-term corporate bonds tacked on 13.2% annually. Emerging market bonds posted average annual returns of 12.3% in the same period, and the high yield market returned 11.5%.
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 years ahead, the odds of a major sell-off in any given calendar year has been relatively low if history is any indication. A look at the numbers:
High yield bonds have produced negative returns in only four years since 1980, as gauged by the JP Morgan High Yield Index. While one of these downturns was huge – -27% during the 2008 financial crisis – the others were relatively modest: -6% (1990), -2% (1994), and -6% (2000).
Emerging market bonds have suffered losses in only four calendar years since 1994: 1994 (-18.93%), 1998 (-14.35%), 2001 (-0.79%), and 2008 (-9.70%). All returns are based on the JP Morgan EMBI+ Index.
The Barclays Aggregate U.S. Bond Index – which incorporates Treasuries, corporates, and other investment-grade U.S. bonds has gained ground in 32 of the past 33 years. The one down year was 1994, when it shed 2.92%.
These downturns, while perhaps frightening at the time, proved manageable for long-term investors – and it wasn’t long before the markets rebounded and investors were able to recover their losses.
If this is Indeed a Bond Market Bubble, What Should You Do About it?
In almost every situation, the wisest choice in investing is to stay the course providing your investments continue to meet your risk tolerance and long-term objectives. If you invested in bonds for diversification or to boost your portfolio’s income, they can continue to serve this role even if the market encounters some turbulence in the years ahead.
Instead, a wiser choice may be to temper your return expectations after the strong run of the 2010-2012. Rather than expecting a continuation of the stellar returns the market experienced during this interval, 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. Anytime an investor needs to use the money soon, it doesn’t pay to take undue risk no matter what the conditions in the broader market.
One Final Note…
Pundits have made their careers by publicly calling major market tops, so there’s plenty of incentive to scream, “Bubble!” and enjoy the media coverage that follows. As is always the case with investing, don’t believe everything you hear. If there’s any doubt, here’s an article from the London Telegraph titled, “The bond bubble is an accident waiting to happen”. The date of the piece? January 12, 2009.
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.