The Bond Bubble Explained

Thanks Tony Conte of Conte Wealth Advisors for this clear explanation of the bond bubble!

The past decade has been one marked by quietly inflating bubbles which unexpectedly burst leaving, financial markets reeling, diminishing opportunities for profit, and leaving investors’ life savings in unsettling flux due to volatile securities prices.  The burst and deflation of the technology bubble in 2000 led markets spiraling downward and, exacerbated by the terrorist attacks of 2001, erased a stunning $5 trillion of market value in just two harrowing years. More recently, the burst of the housing bubble helped to weaken markets and played an integral role in the evaporation of $16.4 trillion in U.S. household net worth from spring of 2007 to the market trough in mid-March 2009.

Bubble Bath

With the ever-imminent threat of total hysteria over daily market movements (thanks in no small part to the immediacy of reporting on 24 hour news stations drumming up advertising revenue through the creation of catastrophes, each complete with its own theme song), let’s get a little perspective before we whip ourselves into a frenzy in search of the next big bubble poised to burst.  A “bubble” in financial markets is simply the trading of an asset or security at unreasonably high valuations (eg. over priced stocks) followed by a sudden devaluation of the security, or a crash in prices.  Bubbles are as old as currency and countless numbers of them in varying magnitudes have risen and fallen over hundreds of years.

Some bubbles are fun, others not so much.

Some bubbles are fun, others not so much.

Tiptoe Through The Tulips

Ever heard of the Tulip Bubble?  That’s right, there once was a financial crisis surrounding the price of the popular, and seemingly innocuous flower which must complete a 5 to 7 year gestational period before being harvested and sold as the tulip that we’ve all come to know and love. A Dutch craze for the flower brought from Turkey and Holland led to an insurmountable demand while supplies dwindled due to the many years required for the plant to properly flower and replenish supplies.  At the height of this tulip-mania, some Dutch homeowners were trading their properties for tulips, which saw a 20 fold increase in value in just a month’s time.  The clearly unsustainable valuations collapsed over a period of weeks decimating the value of some tulips to merely one hundredth of their previous prices.  This was in 1636.

The Tulip Bubble

The Tulip Bubble

You see, bubbles are not new and are certainly nothing to panic about, but rather they are something to be wary of and managed with care and caution.

Madge, You’re Soaking In It

The funny thing about bubbles is that we often don’t seem to recognize the formation and growth of a bubble until we suffer the detriment of its decline.  The challenge in predicting even the existence of a bubble can sometimes be overcome with a reconciliation of bare facts.  Let’s lay them out here and see what you think.

In the first three quarters of 2012, roughly $220 billion had flooded into bond mutual funds. Going back just a few years to the collapse of Lehman Brothers in 2008, over that period of roughly four years investors deployed a staggering $900 billion in cash to bond mutual funds.  Many investors look to bonds for safety of principal and stability (relative to equities and some other assets), and fear of investing in more volatile assets seems to have encouraged an exponentially increasing interest in holding bonds and bond mutual funds. What many investors may not realize is that you can, in fact, lose money investing in bonds.

When the price of a bond goes up, it’s yield (the cumulative return of the instrument accounting for not only the bond’s interest rate, but also the price you had paid to purchase the bond) goes down. Could investors be mistaking the rising valuations of bond funds over the past few years as evidence of their supposed safety? The converse is also true: when interest rates finally begin to increase, the value of outstanding bonds is expected to decrease.  The all-time record high prime rate in the United States was 21.50% onDecember 19th, 1980. This means that if you were purchasing a bond around that time, you were lending your money to a company or entity in exchange for a bond certificate which promised that the entity would pay you interest (commensurate with the insolvency risk of the company issuing the bond) around that incredibly high interest rate.

In hitches and starts over the ensuing decades, at least until December 12, 2012, that prime rate has decreased to its current (as of this writing) standing at 3.25%.  Knowing what we know about the effect that interest rates have on the value of bonds in the secondary markets, one might deduce that the 30 year bull run on bonds will have to come to an end if rates are ever expected to go up.  To give you a sense of what this may mean to US Treasury Bond investors, consider this: A 10 year treasury bond issued at a 2.82% interest rate could see a 42% loss in value from a mere 3% rise in interest rates. Meaning, if you’d held $100,000 in these bonds prior to the rise in rates, you would only be able to sell those bonds for $58,000 in the secondary market after the 3% rise.

Stressed!

Stressed!

What To Do?

At first glance, the bond bubble situation may seem dire, but the informed investor may find him/herself well positioned to take advantage of this seeming inevitability.  True, investors have often bought bonds in a flight to assumed safety; however, in times when even the seemingly “safe” investments threaten to veer into a range of volatility, what is an investor to do?  We counsel some of our clients to consider avoiding bond mutual funds in favor of purchasing the individual bonds themselves with an intention to hold those bonds until their maturity.

Fluctuations in the value of a bond that an investor had intended to hold until maturity should minimally, if at all, affect

the investor’s long term expectations of yield. Most bonds are redeemed at a flat $1,000.00 per bond.  If a bond price fluctuates to a value of $900, $800, $700 or even lower, it could still eventually achieve redemption at “par” (that $1,000.00 value for most bonds).  This remains only one of many strategies to utilize this asset class with full understanding of the possibility of a coming storm and the ensuing rude awakening for complacent bond fund holders.

Bubbles come and go, of course, but with proper and prudent management and investment guidance, the average investor still can stand to gain from these perceived threats to our economy.

Anthony M. Conte, MSFS, CFP ® Managing Partner Conte Wealth Advisors, LLC 2009 Market Street Camp Hill, PA 17011 Phone: (717) 975-8800 Fax: (717) 975-0646 tony.conte@contewealthadvisors.com Registered Representative Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Cambridge and Conte Wealth Advisors, LLC are not affiliated.

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