You Should Still Beware of A Bond Bubble

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.

Reference:

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Comments

  1. enoynmous says

    A 3 year CD paying 2.5% is much less risky than a 10 yr UST paying 2.6%

    let’s assume that the CD/UST is held in a tax deferred account

    IF rates on the longer end of the yield curve rise over the next 3 years, then certainly, the CD is going to win

    IF rates on the longer end of the curve fall, however, then the UST is going to win.

    So when you state that a 10 yr UST yielding the same as a 3 yr CD is ‘riskier’ I believe it would perhaps be better to say that the asset in question, when held in ISOLATION, has higher volatility (due to its longer duration), which of course is a function of increased sensitivity to changes in the interest rate.

    Higher volatility, especially when negatively correlated with other elements of the portfolio, may actually reduce risk adjusted returns of the entire portfolio when viewed as a whole – one of the central tenets of mpt.

    Moreover, the risk of rates falling, and thus losing out on future yield, remains present whether the UST is at 2.6%, 4.0% or 10.0%.

  2. enoynmous says

    I’m not arguing that the yield curve and forward curves are predicting anything other than the 10 year rising in yield. Of course, this prediction component of the bond market has failed in the past (and similar ones have failed spectacularly in the past also – see 2007 10 yr TIPS-nominal treasury breakeven analysis – at the time it predicted a future inflation rate of 4+% for a period, and a year later it was predicting essentially 0% – whoops!).

    My point is simply that your analysis of ‘riskiness’ in your post is misleading. It
    1.) looks at this asset in isolation
    2.) assumes that implied predictions of the market somehow skew the set of possibilities…

    simply because the 10 year is at 2.5% does not mean that it is any more likely to see its yield rise or fall. Nobody knows where yields will be in 3 years – WAY to many variables.

    Perhaps a better question would be:
    given the choice between a 10 yr CD and a 10yr UST, with the CD yielding enough extra that even after exercising the implicit put option is> the yield on the 10 yr UST, which is the better investment.

    Assuming liquidity does not matter, then perhaps the CD would be, but I certainly have not been able to find a 10 yr CD with a yield of >2.5% that stay with as high of a yield after early breakage…

  3. TFB says

    enoynmous – If one prefers to lock in for a longer term, PenFed offers a 7-year CD at 3.75%. Even if you earn zero for the remaining 3 years, you still come out ahead than a 10-year Treasury at 2.6%.

    (1 + 3.75%) ^ 7 = 1.294
    (1 + 2.6%) ^ 10 = 1.293

    In addition, the interest from the CD compounds at the same stated rate of the CD. The interest from the Treasury note is subject to reinvestment risk. If you are predicting falling rates, you will have a hard time reinvesting the interest at 2.6%.

    You break a CD only when it’s beneficial to you; otherwise you hang on to it. The option adds value to the CD. You don’t have that option with a Treasury note.

  4. enonymous says

    If I could get the PenFed CD in a tax deferred account, then I do believe it would be a clear cut free lunch.

    The location problem though, means that my yield on the PenFed 7 yr = 2.063%, after taxes (35% marginal, 9.3% state).

    Since 2.06<2.5, even given the longer duration of the UST (10yr), the fact that I can hold it in tax deferred space makes it a better fixed income investment.

    If we were talking about fully taxable investments, I would agree wholeheartedly that the 7yr PenFed is the better deal.

    I prefer the 5% Ohio 529 CD (10-12yr) as this is tax free growth and tax free at withdrawal as long as used for educaton payments/ room and board…

    The best I can do at my fidelity tax deferred accoutn is 2.7%, on a brokered CD, which has no simple put option (the price drops if rates rise, and they are also less liquid than the USTs).

    Am I missing something?

  5. enonymous says

    1.) yes I have IRA’s at Fidelity, Wells Fargo, and Vanguard
    2.) I wasn’t aware of the partial transfer option – I’ll have to look at the potential fees, not just to transfer to Penfed, but also to potentially then transfer back: if we are to assume zero transfer fees from Fidelity to Penfed, that is good, but not sufficient. If CD rates rise, presumably I could break the CD at Penfed, then get a new one, but what if the UST becomes more attractive – then transfer fees out from Penfed become an obstacle.

    do you hold CDs in a tax advantaged account at Penfed? If so, I would agree, this 7r at 3.75% is clearly > UST at 2.5%, my concern is that the account then becomes restrictive – It’s basically only good for holding cash/CDs/MMF at Penfed (which is great now, but who knows in the future…)

  6. TFB says

    I don’t have an account with PenFed. It looks like it’s free both ways. Please confirm with customer service on both sides.

  7. enonymous says

    thanks!

    this is definitely worth looking into

    I wish Fidelity had better CD offerings, but they don’t – would be so much easier!

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