Are Bonds the Next Bubble?

Includes: HYG, PHB
by: Kurt Brouwer

Is there a bubble or just plain, old fashioned trouble brewing in the bond market? As you can see from this chart, interest rates moved up steadily from the mid-1970s until 1981. The big spike began in 1979 when Paul Volcker became head of the Federal Reserve. He was tasked with the mandate of defeating inflation, and aggressively moved to raise interest rates and slow down the economy. As a result, investors in long-term bonds got crushed as bond prices fell precipitously.

That was not viewed back then as a bubble, but rather as a bear market for bonds. After rates peaked in late 1981, we began a 30-year decline in rates.

[Click all to enlarge]

Source: Investech Research

Double trouble, toil or bubble?

Is a bubble brewing in bonds? 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. An example of a bubble would be real estate prices in 2006. They rose so far and so fast that they became unhinged from normal valuation metrics.

Even though I do not see a bubble brewing in bonds, it should be clear from the chart above that the long decline in interest rates is largely behind us. However, that was a very unusual period for interest rates. This chart of U.S. government bonds over the past 200 years puts the interest rate spike of the early 1980s in a long-term historical context:

Source: Barry Ritholtz

As you can see, we were in a very unusual high interest rate environment in the late 1970s and early 1980s. That is now over and bond yields are in a more normal range. They could go higher or lower from here, but I believe we should be in a gradual trend of higher rates for several years.

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 bond 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.

Hat tip for Investech chart: Barry Ritholtz.