Is there a brewing bubble in the bond market because interest rates on Treasury bonds and other high quality bonds have fallen considerably? Plus, investors are piling billions every month into bond funds. Naturally, this has led to talk of a bond market bubble.
Bond market bubble argument #1:
The argument for a bond market bubble comes from two trends. First, investors have been pouring money into bonds and bond funds. This is true. Mutual fund investors are still betting on bonds and backing off from stocks. This trend has been underway for a couple of years and it shows no sign of abating. Let’s look at this chart from Clusterstock, based on data from the Investment Company Institute:
Bond market bubble argument #2:
The second point bond bubble advocates make is that interest rates have fallen so far and so fast that they have to go up at some point and this will hurt bond investors. And, it is true that interest rates have fallen consistently since 1981 and that is a long time. Also, interest rates could go up at some point.
Consider this chart of long-term Treasuries that my firm put together a while back. Since then, Treasury yields have fallen further and 30-year Treasuries now yield 3.69%. The point of the chart is to show the trend, which has been down since the inflation peak in 1981.
Source: Brouwer & Janachowski, LLC
Do lower rates and bond fund inflows prove the bubble theory?
In my view, the answer is no. Why not you ask? Consider what a bubble really is. It is an unsustainable rise in prices that becomes unhinged from fundamental investment valuations and principles. In addition, a bubble is characterized by increasingly speculative activities that presume, not just on the future, but on the hereafter.
As you can see from this chart, interest rates moved up steadily from the mid-1970s until 1981. Investors in long-term bonds got crushed in this period with bond prices falling precipitously. That was not viewed back then as a bubble, but rather as a bear market for bonds. Why did interest rates go up back then? Inflation.
This chart shows how low inflation is now compared to inflation in the past. The chart documents 10-year average rates of inflation.
Source: Bespoke Investment Group
The red line shows that the total inflation (as shown by the Consumer Price Index or CPI) over the past 10 years has been 25.97%. That 10-year total is lower than any 10-year total for the past several decades. So, the purchasing power of your money is holding up much better than it has since the 1960s.
As you can see, interest rates peaked in 1981 when inflation was also very high. Now, interest rates and inflation are back to levels not seen in decades. When we factor in the current yield on Treasuries with current rates of inflation, the pricing looks much better as this chart shows:
Source: Bespoke Investment Group
As you can see from the chart, the average real return for 10-year Treasuries was 2.66%. Now, we are at 1.62%. It’s lower, but nowhere near the really low periods when real returns went deeply negative during the 1970s and very early 1980s.
Bond market bubble argument #3:
Finally, there is the argument that the flows into bonds are unsustainable. That could be, but again there is very little actual evidence because the money flowing into bond funds is coming from other yield investments such as money market funds, bank accounts and certificates of deposit.
Where is the money coming from?
I don’t think it is correct that most of the assets pouring into bond funds came from disgruntled equity fund investors. Equity mutual funds had modest outflows, but the billions pouring into bond funds dwarfed the equity outflow.
So, the conclusion I draw from that data is that the assets flowing into bond funds are primarily coming from money market funds, Treasury bills, savings accounts and CDs. As the rates on savings instruments has fallen to near-zero in some cases, the urge to move has proved overwhelming.
As one of many examples, MetWest Total Return [MWTRX] has a 6% yield. Pimco Total Return [PTTDX] has a yield of over 5%. These seem pretty attractive compared to a CD at 1% or a Treasury bill at a smidgen over zero. Or, taxable investors can get a 3%-4% yield on solid intermediate tax-exempt bond funds such as Vanguard Intermediate Tax-Exempt [VWIUX].
Two additional points
First, not all bond funds are alike. That is, if you are buying an intermediate-term or short-term bond fund that invests in high quality bonds, then your risk level is still moderate even if interest rates go up.
Second, if you have chased after the highest yield by purchasing long-term bond funds or high yield bonds funds then you have undertaken a much higher risk level, along with higher reward potential. If you own long-term bonds or bond funds, you will take a hit if interest rates go up, but that does not mean we are in a bubble. It just means the normal cyclical ebb and flow of interest rates and inflation is at work.
Still skeptical, then take a look at this chart — 220 years of bonds
Source: Big Picture
This red bars in the chart shows annual government bond interest rates over a very long period of time. The blue line is an average which is at about 5%. The blue oval shows how amazing the spike in rates during the inflationary 1970s was.
Are Treasury rates low by historical standards? Yes. Does this mean we are in a bubble? No.
It just means that bond holders could take a hit when interest rates move up. However, as you can see, interest rates can stay low for long periods of time. And, until inflation begins moving up decisively, we are unlikely to see a big jump in interest rates.
Hat tip for the 220-year chart: Pragmatic Capitalist