The bond “bubble”, what is a bubble, and what the future holds for bonds for the rest of 2017.
Is the bond bubble about to burst? At least some analysts have already warned it is. Most notably, Alan Greenspan recently cautioned that today’s current low interest rates won’t last forever and that when they start to rise, there will be consequences. Because there has historically been an inverse relationship between interest rates and bond values, one consequence that seems inevitable is a decline in bond prices. But does this necessarily mean a bond burst is imminent?
There is no question that the 30-year bull run in bonds is over. At the same time, the 10-year treasury hit a new year-to-date low of under 2.10% this week. This means that while we may be at the end of the ninth inning when it comes to the bond bull market, we still have a few pitches left in the game of generationally low rates.
Bubbles and Bonds
A bubble happens when valuations are ignored and people begin to buy on pure speculation—namely, because they think they can sell at a higher price and benefit from a quick turn on investment. This happened during the dot-com bubble in the early 2000s and again during the housing bubble in 2007 to 2008. In both cases, a surge in asset prices, which were ultimately unwarranted, was followed by a massive sell off. But is this likely to repeat itself in the bond market?
The short answer is no, and the reason for this is simple: No one is buying U.S. government bonds because they are looking for a quick return on investment. While “irrational exuberance” might accurately characterize the buying frenzies that preceded the dot-com and housing bubble bursts, there is no indication that this is currently happening in the bond market or ever has happened.
Historically, bonds have been considered a stable investment option. Unlike other types of investments, in the case of bonds, an investor (or creditor) is simply loaning money to a government or corporation for a fixed period of time to fund a specific project. Any return on the investment is based on interest. As a result, when interest rates surge, bonds become a less attractive financing option and lose value. Still, bonds generally remain a relatively stable investment because with or without high interest rates, the need for bonds persists. This may explain why bonds, unlike most other types of investments, rarely if ever even make headlines.
What the Future Holds
To predict what is about to happen to bonds, we need to predict what is about to happen to interest rates, and predicting the future is no easy task. This task is further complicated because the current market is currently treading new ground. If you had asked several years ago, we would have expressed our expectation that rates would be much higher than they are today and they aren’t. Simply put, we’ve never seen a central bank response with the scale of stimulus and accommodation we’ve witnessed since the 2008 economic recovery, and there is no clear path forward.
Regardless of the pace and rate of interest rates moves from here, we believe our tactical approach to fixed income lends itself favorably to the environment. The future direction of interest rates is not our primary concern, at least when it comes to investing in fixed income securities like bonds. By tactically investing in a sector that does not list interest rates as a top risk, one can avoid much of the vulnerability about which Greenspan and other analysts are currently warning.
The bottom line is that the bond bubble is not about to burst, but it does seem likely that moving forward, traditional bonds will be more volatile and lower yielding than they have been over the past three decades. Despite this prediction, however, there is no reason to abandon bonds entirely. Instead, a tactical fixed income approach should prove a beneficial allocation as part of any diversified portfolio.
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