The Bond Expectations Bubble

By Charlie Bilello

“By any measure, real long-term interest rates are much too low and therefore unsustainable. When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace. The real problem is that when the bond-market bubble collapses, long-term interest rates will rise.” – Alan Greenspan

Alan Greenspan says bonds are in a bubble.

With negative interest rates across Europe and in Japan, it’s hard to argue with him.

But what exactly does it mean to say bonds are in a bubble? Are investors in a broad bond index fund going to experience a similar fate as tech investors back in 2000 (>80% losses)?

Not likely. Bonds are a completely different animal than stocks. While losses can occur during periods of rising rates, they pale in comparison to equity market declines.

Going back to 1976, the worst drawdown for the Bloomberg Barclays Aggregate Index was 12.7% (versus over 50% for U.S. equities). This occurred from August 1979 to March 1980 when yields moved from 9.5% up to 14.1%.

The drawdown didn’t last very long. By May 1980, bonds were at new highs, and investors never saw a negative calendar year return at the time.

How is that possible? Yields were so high in the late 1970’s that the coupon payments outweighed the losses from rising rates. (Bond Math note: the higher the starting yield, the lower the duration (sensitivity to rising rates) and vice versa).

In 1994 when yields moved from 5.8% up to 8.2%, there was less cushion in terms of coupon payments. The result was a 2.9% loss for the year. A more extreme example can be seen in 2013, as it only took a minor rise in yields (1.7% to 2.5%) to bring about a 2% loss on the year.

Where does that leave us today? In a similar place to where we were five years ago: a precarious position.

And what has happened over the past five years? Bond investors have experienced their lowest 5-year annualized returns in history: 2.0%.

Should this have been a surprise? No. The single best predictor of future bond returns is the beginning yield.

So are bonds in bubble? Of course they are. How could they not be when central banks in Europe and Japan are manipulating interest rates to such an extent that borrowers are being paid to borrow.

If interest rates rise from here, bond investors are going to get hit. And if rates rise as much as they did in the late 1970’s, bond investors are going to get hit much harder than back then (because starting yields are low, duration is higher).  What are the odds of that happening? I don’t know, but investors cannot rule it out entirely.

Still, the collapse of any bond bubble is not likely to come anywhere near the collapse of an equity bubble in terms of percentage declines. Absent default, bond investors holding until maturity will receive their principle back. They will incur interim losses as rates rise, but prices will ultimately move back to par.

Which is why the bigger bubble in my mind is in the high expectations of bond investors, many of whom are still living in the dream world of yesteryear, when bonds yielded 5%, 6%, or more. The dreamy historical annualized return of 7.5% from bonds (Barclays Agg since 1976) is just that, a dream.

Until the bubble bursts and interest rates rise significantly, bonds are not going to come anywhere near such a return. Which is why long-term bond investors should actually worry more about the bond bubble not bursting (rates remain at historic lows) than bursting (rates rise and short-term losses ensue, but future returns improve).

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