There is no bubble in bonds.
Lots of loose talk and lazy reasoning is making the rounds, insisting that the rally in Treasury bonds that dropped 10-year U.S. government yields below 2.5% recently is a dangerous bubble.
Headlines such as “How Not To Get Soaked When the Bond Bubble Bursts” and “Bond vigilantes routed as bubble forming” have taken the likelihood of a global speculative mania in bonds for granted. Almost a year ago, senior Bank of England policy maker Andrew Haldene lent legitimacy to this view by asserting: “We have intentionally blown the biggest government bond bubble in history.”
The trouble is, today’s bond market — especially the government bond market — doesn’t satisfy most of the standard criteria for identifying an asset bubble.
As I discuss in the attached video with Yahoo Finance Editor-in-Chief Aaron Task and The Daily Ticker’s Henry Blodget, investment bubbles are quite rare, and commentators have become too quick to throw the label around in the years following the tech-stock implosion and housing mania of the past 14 years.
Nobel Prize winner Robert Shiller of Yale University, who warned presciently of the stock and housing bubbles, has devised a checklist of asset-bubble characteristics that can be used to identify one.
Let’s go through several of them in turn, to test the idea that bonds are bubbly:
Sharp increases in the price of an asset. Bonds have performed well recently, with long-term Treasuries returning more than 12% in the first five months of 2014. And their sharp outperformance has certainly surprised the consensus. But as a group, they’re flat over the past year, and this magnitude of price gains hardly qualifies as a powerful surge.
Great public excitement about said price increases. Hardly. Investors have ample investments in bonds, but they are mostly confused by the fact that yields have stayed so low. And, as Task notes, continued heavy outflows from Pimco Total Return Fund (PTTRX) – the largest bond fund, run by investing superstar Bill Gross – reflect the public’s unease with owning bonds.
An accompanying media frenzy. If there is a media frenzy, it is mostly concentrated in shrill attempts to scrutinize the bond rally, to ask whether it makes any sense, to declare that it can’t last. If bonds are in a bubble, it would be the first one that formed while the press warned constantly that the asset was risky and unattractive.
Stories of people earning a lot of money, causing envy among those who aren’t. Where are the amateur bond speculators’ yachts, and the gushing articles about their easy riches and lush lifestyle? The Nasdaq boom had day-trading plumbers, and the housing frenzy had house-flipping cable-TV shows. Nothing like that is now evident surrounding bonds.
“New era” theories to justify unprecedented price increases. This is the one feature that has sometimes accompanied the strong performance of bonds. The “structural stagnation” idea that Western economies will be trapped in subpar growth mode for years to come, espoused by former Treasury Secretary Lawrence Summers, has plenty of adherents. And faith in central banks’ resolve to reflate the economy with very low rates for a very long time has become pervasive.
Still, this alone doesn’t energize the kind of “greed story” that presents bonds as a can’t-miss bet, as much as it seeks to explain the low-rate “conundrum,” along with ideas of demographic demand for bonds and the global scarcity of safe yield. The existence of a plausible fundamental basis for the action in Treasuries argues against the notion that it's all made-up "new era" talk.
As Blodget correctly points out, even if bonds are not in a bubble, that doesn’t mean investing in them is an easy or attractive option. Bonds can prove a poor investment at these levels, leading to on-paper losses if rates trend back toward more “normal” levels.
Yet the worst-case scenario for Treasury investors is that the U.S. government will repay them at 100 cents on the dollar, while perhaps the yield fails to compensate for inflation.
Bond-fund shareholders could suffer mark-to-market losses if rates spike, which tends to unnerve retail investors, but those funds would then be able to reinvest proceeds of maturing bonds at higher rates, offering the kind of long-term protection and diversification that bonds are meant to deliver in a broad portfolio.
Arguably the most aggressive, frothy activity is occurring not in government debt, but in high-yield “junk” bonds and related corporate loans. Lower-rated corporate debt now yields a scant 5% or so, and money continues to flow into this market as investors stretch for income and take heart that the economy is stable and bond maturities scarce in coming years.
Even though this might not yet be a true bubble either, lending standards have loosened the way they tend to in bubbly markets, and the risk-reward now looks unattractive for long-term investors.
Central bankers might also look to knock the over-generous credit markets back on their heels with some tough talk to forestall further excesses from building, as they did early last year. This could cause the kind of gut check that most overconfident junk investors don’t see coming.