by Doug Drabik, Fixed Income, Raymond James
A ābubbleā in our industry is often referred to when exhuberant investor behavior, even absent supporting fundamentals, hastily drives the price of an asset to an elevated level. Bursting the bubble occurs when a more fundamental, logical or justified price ensues potentially creating major losses for the investors still holding the asset.
The ābond market bubbleā vernacular has once again appeared in the news; but donāt believe everything you read. Applying the slang expression to bonds may be like trying to force a square block through a round hole. First, there is nothing hasty, rapid or swift about how bond prices have become elevated. Since Treasury interest rates peaked in September 1981, they have been in a general interest rate decline (nearing 36 years), meaning pricing has been generally trending up for a very long time. Remember that price and yield react inversely. It also could be argued that fundamentals are a primary driver in explaining why interest rates have moved. In addition, unlike other asset classes that have been in a bubble (more recently the dot.com market from 1997-2000 or the real estate market bubble of 2007-2009), bonds have stated maturities. That is, bond investors who hold their bonds to maturity in essence eradicate the effects of interest rate volatility experienced during the holding period and receive their face value at maturity. In summation, bubbles imply not knowing an exact purchased value as itās emotionally charged whereas a purchased bond is about as precise as it gets with defined parameters of known income and maturity.
Many credible and even iconic pundits have made what could be considered irresponsible statements regarding bonds without any qualifiers to individual circumstances. Unfortunately we live in a world where sensationalism and āshockā statements sell viewership and readership. For the typical investor, asset allocation includes bonds which maintain favorable structure characteristics and fulfill financial needs regardless of interest rate levels. Bonds are often purchased for their defined income. The positive total returns that bonds have experienced over the years have been a sort of bonus but may cloud the real purpose that bonds often serve for investors seeking income and protection of wealth.
Actually, many pundits believe interest rates are going to remain low for some time. There are a multitude of reasons low interest rates could persist. Among these reasons: global interest rate disparity in which US rates are elevated relative to other economic super powers. Search for anything with yield keeps demand strong and thus impedes rising rates. Global Quantative Easing programs (ECB and BoJ) are ongoing and creating money that could mitigate any effects of the US ābalance sheet normalizationā.
This entire notion of a ābond bubbleā may be much more valid for funds that hold bonds rather than individual bonds themselves. In the absence of default, individual bonds will perform exactly as intended from date of purchase to maturity. In other words, the cash flow, income stream and the date the face value is returned to the investor will not change and is determined at purchase when bonds are held to maturity, REGARDLESS OF ANY INTEREST RATE VOLATILITY during the holding period. On the other hand, funds holding bonds always carry a different risk to principal since they are tied to a net asset value (NAV) which may or may not be effected with interest rate volatility.
Perhaps itās merely terminology, but put a pin to the idea of a bond bubble.
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To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Associationās āLearn Moreā section ofĀ investinginbonds.com, FINRAās āSmart Bond Investingā section ofĀ finra.org, and the Municipal Securities Rulemaking Boardās (MSRB) Electronic Municipal Market Access System (EMMA) āEducation Centerā section ofĀ emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the reportās conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
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