Recently investors have voiced apprehension over a bond market bubble. There is no bond market bubble.
Fundamental statistics reviewed suggest the bond bubble idea might be out-of-place. Data reviewed, (shown below), suggest the bond market has been rational and that bond investors have experienced attractive real returns. It is worth repeating, bond investors have enjoyed attractive real returns.
The equity investor may advocate that bond investors lose out to inflation. That is a valid concern as bonds have a fixed coupon. However, the equity investor often does not mention that historically the dividend yield has been less than the bond yield. Therefore, the equity investor may trail the bond investor when measured by the real cash return that ignores price changes. Take IBM (IBM), according to Yahoo Finance the May 4, 1989, dividend was $0.3025 per share for a 6.74% dividend yield. This level of dividend payment was not exceeded for 18 years or until the May 8, 2007 payout of $0.40, which is unadjusted for inflation. The cash return to IBM stockholders failed to keep pace with inflation. The May 1989 Standard and Poor's bond guide showed IBM with a credit rating of AAA with its 9.375% of 2004 at 98.375 of par for a 9.58% yield. Bond investors enjoyed a 284 basis point yield pickup verses common stockholders and did not experience a decline in cash income unlike stockholders that saw the dividend decline to $0.0625 in 1993 until early 1996.
The data below will show that investors in the 10-year U.S. Treasury have generally outpaced inflation. The 10-year U.S. Treasury yield is compared to the 10-year annualized CPI. The CPI line is shifted to show the actual average inflation rate over the life of the bond. When investors today suggest that the 10-Year U.S. Treasury Yield is less than inflation, they are making an assumption for inflation during the next decade. Should deflation occur then the real yield on the 10-Year would soar.
For bond investors that cut their teeth during the 1970s and 1980s the current level of interest rates might give the appearance of a bond bubble. In 1989, a 15-Year AAA credit offered a yield of nearly 10%. What do you think would have happened to an analyst that said the U.S. Government would run massive budget deficits, have its credit rating cut and that interest rates would fall? Alternatively, that the AAA credit IBM would be an AA- credit but have 15-Year paper yield under 3.50% and its 2096 issue yield under 5.00%. It is 4.88% according to the FINRA website. Most likely, a short career, would you agree?
The fixed income markets may have been malfunctioning until recently. If one adheres to a risk-return model. Greater risk should correspond to a greater expected return. Therefore, less risky cash should yield less than more risky bonds. Less risky bonds should yield less than common stock. This suggests that cash and other short-term debt should yield less than longer-term issues, or a steep yield curve.
The charts and data shown below suggest that the bond bubble theory might be over-blown.
Look at Japan. The employment-population ratio has fallen with bond yields. There was a long decline in interest rates followed by roughly 15 years of sub 2% yields. Why could not this be the future of U.S. Treasury yields? Since 2000, both the employment-population ratio and interest rates have declined in the U.S.
The next chart is the spread between BB bond yields and the constant maturity 10-Year U.S. Treasury Yield. This is the higher-risk segment of the bond market, or the high yield sector. The spread has been declining, but needs to decline further to establish record low spread. The nominal yield on high yield is low by historical standards. The spread can narrow by either the 10 year yield backing up with stable high yields or high yield rates declining. Why would high yield rates decline? An improving economy could improve the credit quality making it less risky. In addition, an improving economy could take some of the fear bid out of U.S. Treasuries.
Next chart displays federal outlays as a percentage of Gross Domestic Product. A reduction of U.S. Government spending might reduce the need to issue debt. This could reduce the supply of bonds. Should demand remain constant then yields may settle into a narrow trading range of +- 30 basis points. Fewer bonds can create a problem. What will financial institutions accept or use for collateral? The Wall Street Journal recently had a story on a shortage of bonds resulting in an increase in failed trades. Large "blue chip" once enjoyed AAA ratings, but that is a small group today. For example, what instrument could be used as a good faith deposit in the futures industry?
Spending as a percentage of Gross Domestic Product is falling. The slow and steady increase in GDP may be more a factor than a reduction in spending. Since 1980, spending as a percentage of GDP declined until 2000 then it turned higher. The growing economy and spending constraint is helping to reduce the debt burden, but it needs to fall further.
President Reagan and President Clinton were in office while government outlays stabilized and then declined as a percentage of GDP.
Money Velocity Versus Consumer Price Index
The chart below suggests that the velocity of money needs to stabilize and or turn up before inflationary pressures should become a major concern. It is always a good an idea to worry about inflation, but do not forget about deflation. Which is worse for economic growth - falling (deflation) or increasing (inflation) home prices?
Yearly Change in the Consumer Price Index versus the 10-Year Treasury Yield.
Bondholders have experience real yields.
The 10-Year rolling CPI is falling.
Real 10-Year Yield. (Rolling 10-Year CPI with 10-Year Yield shifted 10-years). Bond investors have enjoyed multiple decades of attractive returns.
Fixed income investors worry about inflation. Unfortunately, the CPI (Consumer Price Index) is a backward looking index. It tells us what has happened - not what will happen. In the 1980s and 1990s investors generally did not want to consider bonds. Why? The inflationary shocks of the 1970s may have spooked fixed income investors. In addition, those interested in bonds generally did not like US Treasuries but favored higher yielding issues such as CMO's, Mortgage-backed debt, and corporate issues. The higher yielding issues offered a higher yield for a reason; many issues were callable, unlike most U.S. Treasuries that were generally non-callable. When market interest rates are lower than a bonds coupon the issuer may call the bond. This can reduce the income to the investor.
U.S. Treasury issues do not offer the generous yields they once did. That does not mean there is a bond bubble. Economic theory suggests bonds should yield less than common stocks.
The expectation for U.S. Treasury issues is that they will generally be in a narrow trading range of say 50 basis point, higher or lower. This range will provide nimble traders the opportunity for attractive returns while helping the economy regain its footing before heading higher. Will inflation one day become an issue? Yes. It is difficult to see the driver for inflation given the unemployment situation, capacity utilization rates, the velocity of money, the ongoing deleveraging, and the fear of uncertainty. An outburst Inflation does not appear to be on the horizon. Of course, I could be wrong. Time will tell.
Bond ETFs to consider. Investment High Grade (LQD), High Yield (HYG and JNK), Total U.S. Bond Market (AGG), Total Bond Market (BND) and Short-Term Bond (BSV). These are some of the larger bond ETFs for a portion of most any portfolio. Be aware that higher interest rates may cause the value of the bond ETFs to decline.
All comments are welcome.