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I continue to be amazed at the amount of "bubble" commentary being blown the bond sector's way. The omnipresent argument seems to be that since interest rates are historically low, they have nowhere to head but higher, and this somehow creates a bond bubble. While it's undeniable that rates are low and may go higher in time, this does not mean all bonds, or any bond for that matter, is in a bubble. Bonds may be a pretty lackluster total return idea going forward, but the "bubble" tag is an unnecessary and perhaps irresponsible nameplate for an otherwise stable, dependable asset.

10-Year Treasury Yield - 30 years

(click to enlarge)Bubble Defined

The problem with applying the term "bubble" to bonds is that it is such a grossly vague concept for such a broad asset class. From my perspective, the use of the word bubble appears more sensationalistic than realistic. So what exactly would have to happen for historians to look back at current bond pricing as a bubble? There are a couple of scenarios.

First would be a situation where rates climbed by several hundred basis points over a fairly short period, creating a huge paper loss or opportunity cost situation for those currently invested in intermediate and long-term maturities. This would be indicative of cyclical strengthening of the economy, whereby the Fed discontinues QE, macroeconomic indicators do a quick about face, inflationary pressures increase and a tightening bias is forced upon us by the Fed to cool down expansionary heat. Rates would remain high for a sustainable period of time, creating massive opportunity cost, but benign credit risk, for buy and hold fixed income investors.

Second would be a return to a recessionary environment where rates stay low, limiting impact to investment grade credit, but causing a hiccup in below investment grade credit. Default rates in junk bonds would precipitously rise, with aggressive bond investors incurring increased capital loss. Panic would like spread to other tiers of the bond market, causing massive pricing inefficiency. This would be similar to the hiccup experienced in the bond market four years ago, when high-yield defaults reached the low teens. But this time, default rates would go higher and spread to below investment grade paper, with the impact much longer and more pronounced than 2009. Credit markets would again recover, but this time it would take a more lengthy amount of time to do so.

The last scenario would be of the doomsday variety where the global economy collapses, creating a quasi-depression where junk debt sells for pennies on the dollar, investment grade credit becomes the exception rather than the rule, and panic spreads across all major financial markets. There is a mass flight to hard assets, with the economic pain lasting a decade or more and recovery taking, again, a decade or more.

Reality Check

I'm not inclined to believe that any of the three above scenarios will come to fruition. Instead, I'm of the opinion that rates will remain steady and low for the foreseeable future, with the global financial market malaise laboring on. In a market/economic outlook article I wrote last year, I predicted that "the last decade might become the last decade" as far as financial markets are concerned.

And though it would not shock me if the Fed initiates a tightening bias over the next couple of years, I'm at a loss for trying to envision a scenario, given current economic realities, where rates zoom ahead. The housing market is still in a bottoming out process, the middle class is still struggling, Europe is a mess, and Washington has no clue how to help out. Domestically, we're in no position to handle higher rates, and with QE continuing on and on and on, we need to first experience a "QE-less" environment. Then we can turn to executing more normalized monetary policy. This will undoubtedly take time.

Still, I'm not of the camp that thinks a disaster is brewing. Yes, we have our problems domestically, and yes Europe is a mess, but there's no reason to believe that we are headed back to the 1930s. I am somewhat concerned at what happens when QE is discontinued and the potential for further downgrades of U.S. sovereign credit. But despite the negatives, companies are growing earnings and GDP is keeping its head above water.

U.S. GDP Growth (YOY Quarterly)

(click to enlarge)

Thus, given my perspective, it would appear that a contractionary floor and expansionary ceiling have been somewhat established in the current economy, giving rise to support for a continued low, stable interest rate environment. So other than the repetitive, stale argument that bonds are "risky" because rates "have" to go higher, there's no reason to be blowing bubbles over bonds in my view.

Buying Smart

While it's somewhat difficult to be a bond bull given low rates, it does not mean that someone should not utilize them as part of a diversified investment program. Those with a well laddered portfolio may be able to basically ignore day to day rate noise and continue to buy long-term paper knowing that blended portfolio maturity risk is muted. However, strategically speaking, I don't think I'd stray too far from intermediates, as even a mild uptick in rates can have profound impact on multi-decade maturities.

And with default rates still low, junk debt does not seem like a terrible idea, although for those without much of a desire to analyze credit, I'd probably opt for a fund. I recommend Western Asset High Yield Opportunities (NYSE:HYI), trading at a discount to NAV and yielding roughly 8.5 percent. While I'm not a huge fan of funds, I think investors benefit from the diversification here and a short, 5-year blended maturity. For investment grade municipal and corporate debt, I strongly recommend individual issues, with no ongoing management fees to erode yield and little to no capital risk compared to owning a fund.

HYI - 1 Year Chart

Conclusion

Though detractors have been blowing bubbles at bonds for years now, I seriously doubt we are on the cusp of an economic upheaval that will send a lasting shock wave through this dependable asset class. I would concede that risk has elevated through the potential for a rising rate environment and total return attraction is minimal. However, to summarily categorize mammoth risk in an asset possessing a contractually bound and sometimes insured return of capital feature is simply absurd. The opportunity cost inherent in a prudently purchased bond in today's market is nothing compared to the potentially permanent capital risk every equity investor takes when entering a stock buy order.

Source: The Absurdity Of A Bond Bubble

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.