As interest rates go down and down, people have raised warnings for a possible bond bubble. Vanguard, being a major provider of bond mutual funds, has published several white papers and articles trying assure investors they should stick to bond funds and not worry about a bond bubble.
Unfortunately the arguments put forward by Vanguard are not 100% logical. The short story is that investors should still beware of a bond bubble.
Before I continue, I should define what a bond bubble is. I see the bursting of a bond bubble as "substantial rise in interest rate causing losses in bonds." As you must know, bond values are mathematically determined by the prevailing interest rate. If interest rates go up, bond values go down.
Now let’s look at some of the arguments in Vanguard’s articles.
"There is no bond bubble."
Denial is always the first line of defense. Vanguard wrote in its recent article Should you beware of a bond bubble?
Investors should be skeptical, according to Joe Davis, Ph.D., Vanguard’s chief economist. "A bond bubble would imply not only that U.S. interest rates have to rise dramatically in a short period of time (as if dictated by some law of gravity or reversion to the mean) but also that the increased demand we have seen for Treasuries has been irrational and unsupported by market fundamentals," Mr. Davis said. "I take some issue with both points."
Investors driven by poor performance of the stock market seek safety in bonds, especially US Treasury bonds. This has pushed down the bond yields to historical lows. The chart below shows yield on 10-year Treasury since 1962 (source: St. Louis Fed). It’s at a 50-year low except a few weeks in early 2009.
Saying there is no bond bubble is like saying interest rates will stay low and never go up again. Maybe, maybe not. Although it’s possible the United States will have another two decades of slow growth and low interest rates, like Japan since the 1990s, it’s also possible that growth will resume when we get out of the recession. 10-year Treasury yield is 2.6% now in August 2010. It was 4.0% in April 2010, just four months ago. Can it go back to 4.0%? Absolutely. 4.0% is still quite low. If it goes back to 4.0%, bond investors will suffer a loss.
Interest rates going up is a risk for bond investors. We should not dismiss it as if the risk doesn’t exist.
"There may be a bond bubble but it’s not going to burst any time soon."
Vanguard also wrote in the same article (emphasis mine):
"According to recent Vanguard research, the rise in the U.S. household savings rate has been another important factor in lowering U.S. interest rates, a recent development that could persist for some time given the current economic backdrop."
This is like saying playing chicken is OK because the train isn’t coming yet. Not a good strategy in my opinion.
"A bond bubble is not as bad as a stock bubble."
Vanguard’s article continued with:
"Mr. Davis also stressed that if a bond bear market caused by some future rising-rate environment does occur, most diversified, long-term investors should not regard it with the same level of apprehension as they would an equity bear market, where short-term portfolio losses can be more severe."
I get it. Cutting a finger off is not as bad as cutting an arm off. So? Although it’s true that a bond bubble is not as bad as a stock bubble, investors still lose money when a bond bubble bursts.
"You will make more money in bond funds over the long term if interest rates go up."
When interest rates go up, bond interest and matured bonds can be reinvested at a higher rate. Eventually you will make more money than if the interest rates didn’t go up. This argument is more subtle and confusing. It’s another one of those true-but-irrelevant logic traps.
Vanguard has shown this table in a few articles, including one published in February 2010, Bonds and rates: The reality behind the headlines:
The table shows that if interest rate goes up from 4% to 6% over two years, a bond fund with a duration of 5.8 years will earn 4.7% per year over ten years versus just 4.0% if the rates stayed at 4%.
You might be convinced until you understand what the table is really comparing. The fact that you will make more money over the long term if interest rates go up is not relevant to the question at hand: whether you should buy or stay in bonds today. All the higher returns are earned after the rates go up, not during the time the rates go up. You will be able to benefit from the higher interest rates anyway if you buy bonds after the interest rates go up.
If we back out the higher returns you will get after the rates go up (because they are the same whether you buy or don’t buy bonds today), we are left with the period of time during which the rates go up. Suppose interest rates go up from 2.6% to 4.0% in the next two years, a bond fund with a duration of 6 years will lose 1.4% * 6 = 8.4% on the principal. That will more than offset the interest payments during the two years and give the investors a net negative return. Clearly an investor is better off putting money in a 2-year CD paying 2% a year.
So should you buy or stay in bond funds today when interest rates are at historical low?
It depends on where you see interest rates are going. If you think interest rates are going down, instead of up, you should buy bonds, and buy long term bonds. Long term bonds pay more in interest than short term bonds. As interest rates go down, your long term bonds will also get a capital gain. Maybe the game will still go on for some time. Enjoy. Just remember to get off the railroad tracks before the train comes. I’m not comfortable with this risky strategy.
However, if you see a risk of interest rates going up, you are better off taking shelter in CDs. A 3-year CD paying 2.5% a year is much less risky than a 10-year Treasury paying 2.6%. The cost of being conservative this way is really low. Some CDs have a cheap embedded put option: if rates go up substantially before the CDs mature, you can pay a small early redemption penalty and reinvest at the higher rate. That’s even better.
- Bonds and rates: The reality behind the headlines, Vanguard Insights, February 2, 2010
- Deficits, the Fed, and rising interest rates: Implications and considerations for bond investors, Vanguard Research, March 2010
- Risk of loss: Should investors shift from bonds because of the prospect of rising rates?, Vanguard Research, July 2010
- Should you beware of a bond bubble?, Vanguard Insights, August 3, 2010