For some time now, I have been hearing the current US Treasury market (and therefore fixed income markets priced off the "risk free") referred to as a "bond bubble". The concept of the current market being a bubble market is a fallacy.
In order to best understand the fallacy, one must first define "bubbles" and then put them in context.
A "bubble" has, as I see it, two defining characteristics:
- demand (real, perceived or expected) outstrips supply (again, real, perceived or expected) which leads to increasing prices for a good, service or sector which then feeds on itself and leads to speculative excess, and
- Speculative excess occurs when participants perceive a high probability of outsized returns.
Applying these characteristics to the last two 'bubbles' we have witnessed:
- Dot com (TECH) bubble of 1998-2001. With the IPO of Netscape the investing world was turned on its head. Here was a technology that was going to revolutionize the way we did business and shared information. The demand for this technology was going to be huge, growing far faster than supply. This "new era of productivity" promised outsized returns to those who participated. IPOs of companies barely outside the concept stage would triple right out of the gate. Investors perceived gains that were awe-inspiring - and those who got out in time realized these gains. No one wanted to be the guy not involved in the action (remember the criticism Warren Buffett took?). Perceived demand, quick to market supply, perception of outsized returns. Remember E-Trade - Money coming out the wazoo? Pets.com? Demand was everywhere, eyeballs were the metric. Perception of demand and outsized returns. Speculators. Pop.
- Housing bubble of 2001-2008. With rates headed lower thanks to the Fed, and the accompanying easy credit provided by banks, the real-estate bubble was the "new, new" thing. Demand for housing - for both occupancy and investment - was outstripping supply which lead to ever increasing prices and the belief that "this time it is different" and housing prices would only go up. To meet this demand, supply was being brought on line as fast as possible and where there was "shortages" bidding wars ensued. Perceived imbalance, probability for outsized gains. Flip this house, spec building and cheap credit (liar loans, 120 LTV loans...) helped a hard asset sector trade like a financial sector. Perception of outsized returns, speculators, POP.
Now, let's look at the current environment for bonds.
Beginning with the financial meltdown (see real-estate bubble above) of 2007-2008, demand for risk free assets increased nearly exponentially.
Chart via Yahoo! Finance, log scale.
Demand outstripped supply as investors globally sought the safe haven of US Treasuries, driving yields down. Once the situation was "under control" (read over a trillion in backstops and govt cash), yields begin to head back up, rising over 100bps from December 2008 - June 2009. Rates went sideways for nearly a year until April 2010 and the introduction of the "European" crisis. From April 2010 to October 2010 yields fell over 100 basis points. Over the next six months yields rose over 100 basis points. Re-enter European Crisis squared. From April 2011 until now, rates have fallen 150 basis points.
Returns over this period have been significant (from point to point, varying significantly in-between). But have returns lead to speculation and has this potential speculation lead to even higher prices (lower yields)? I would say no. Two things have helped lead rates to where they are:
- Demand for low risk assets and safehavens. During times of crisis, investors will move to safe havens in order to protect their principal and preserve value. The majority of this "bubble" has occurred during times of financial stress. This is a "loss avoidance" trade rather than an "outsized gains" trade.
- Demand for a stable currency. Arguably, the German Bund is a better investment than the US Treasury (due to their ability to live more within their means), but it is still euro denominated. Investors in Bunds get lower yields than treasuries and increased currency risk. If you are China, which do you choose - the lower yield with higher currency and political risk or the higher yield with a more stable currency (I would pick Canada, but they can't handle the demand)?
Ultimately, the bond market is not in a bubble state - yes, there will come a time when the less risky (I can't with a straight face say risk free) asset will pay the piper through higher inflation and the need for higher rates, this is true. Will we see the violent sell-off and correction that occurred with the two prior bubbles? No. The reason is that the largest owners are not speculators (China, Japan, the US Govt itself, Insurers and sovereign funds) and cannot simply unwind the trade (it would be mutually assured financial destruction). Yes, rates will head up, they have to, but it will occur the same way rates have always headed up, it will not be like the bursting of a bubble.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: This article is for informational purposes only, it is not a recommendation to buy or sell any security and is strictly the opinion of Rubicon Associates LLC. Every investor is strongly encouraged to do their own research prior to investing.