Money Matters: Bond bubble revisited - Has it burst?

David Peartree, The Daily Record Newswire

Has the bond bubble burst?

Short answer, no. The longer answer depends on what you mean by “bubble” and “burst.”

Since late 2009 we’ve read repeated warnings that bonds are an investment bubble waiting to burst. Over the past several years, bonds have done unusually well. This year, however, bonds have struggled, especially over the past several months. Most sectors of the bond market, other than high yield bonds, show negative total returns for the year.

Investment bubbles are marked by speculation, investors willing to take on debt to finance their bets, and an investment mania that can be characterized as “irrational exuberance,” all in the pursuit of short-term, ultimately unrealistic returns. Investment bubbles end by bursting, inflicting catastrophic on investors.

The immediate future for bonds looks challenging, but bonds are not by their nature a bubble asset and recent events do not reflect a bursting bubble. What is going on with bonds?

First, interest rates have started to edge up. In May alone, for example, the yield on the 10-year Treasury bond increased by about .5 percent. Remember how bonds work: bond prices fall when interest rates rise.

Second, rates are not rising because the Federal Reserve has started to raise them. In fact, their current policy still aims to keep rates low. The Fed’s control over bonds, however, is far from absolute. Bonds are also subject to basic market forces of supply and demand.

Comments by the Fed in the spring that the economy may grow faster in 2013 than they previously expected led much of the bond market to anticipate an end to the Fed’s easy money policy known as “quantitative easing” or “QE.” That, in turn, caused many bond investors to sell, pushing prices down.

Now for some context and, hopefully, reassurance.

First, remember why we own bonds. Bonds serve three basic objectives: 1) capital preservation, 2) income and 3) diversification due to a low correlation with stocks.

Capital preservation is not a sure thing because bonds can lose value, but bonds historically have done a good job at preserving capital — even at times when rates are rising. Income from bonds has been less than normal because rates are at historic lows. Income will get better, however, as rates rise and return to more normal levels. Low correlation with stocks means that bonds don’t always move in the same direction or to the same degree as stocks. That’s why holding bonds in a portfolio helps to minimize losses when the stock market drops.

Over the past several years, bonds have also experienced significant price appreciation, so much so that investors could be excused for thinking that bonds have a fourth objective, price appreciation or growth. Since 2009 bonds have produced returns well in excess of the income they yield and at times matching or exceeding the average long-term return for stocks.
Growth is not the primary reason we own bonds, however. At least for now, bonds don’t appear to offer any significant growth potential. Over the short-term, bonds may show negative total returns. Over the long-term, bonds should continue to provide positive returns.

The best estimate of future returns from bonds is their yield. For the bond market as a whole, that means likely total returns over the next 5 to 10 years of about 3 percent. Lower than in the past, but still positive, at least on a nominal basis.

Second, a reading of market history supports sticking with a good allocation plan, including bonds, even if rates are rising. All things considered, bond investors would prefer to see interest rates falling not rising. Still, periods of rising interest rates have not been uniformly bad for bonds nor the catastrophe that commentators sometimes suggest.

Over the short-term any losses can be painful because investors are not accustomed to experiencing losses with bonds. Since 1979 there have been five periods when interest rates rose more than 2 percent. In the two worst periods (1983-1984 and 1993-1994), bonds lost value in the short-term. In the other three periods (1980-1982, 1986-1988, and 2003-2006), diversified bond portfolios were able to produce positive total returns even though rates were rising.

How can that be? Over time, interest income represents the lion’s share of the total return from most bond funds. This is particularly true of intermediate term, investment grade bond funds, which are the core of what most individual investors own. Rising interest rates mean rising interest income, and rising income over time can offset the impact of falling bond prices, especially if the income is reinvested.

Finally, remember that a bond bear market can’t hold a candle to a stock bear market. A bond bear market generally involves single digit losses. The worst calendar year in the bond market, 1969, saw losses in excess of 8 percent. The worst 12-month period in the bond market, the period ending March 1980, saw losses in excess of 9 percent. Frustrating and painful, but not a catastrophe.

Stock market corrections of 20 percent tp 30 percent are run-of-the-mill. From 2007-2009 the U.S. stock market lost over 50 percent and from 2000-2002 it lost nearly 45 percent. Despite the challenge posed by rising interest rates, holding bonds is still the best way to diversify the risk of loss from stocks.

The prospective returns from bonds over the next 10 years are almost certainly less than over the past 10 years. Despite their challenges and notwithstanding the possibility of negative total returns over certain periods, bonds remain an important part of a strategic allocation.

Stocks and bonds are complementary, not competing asset classes.

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David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625; email david@worthconsidering.com.

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