Saturday, June 12, 2010

Bond Bubble?

A recent Wall Street Journal article titled "Bond Fund Managers See Signs of A Bubble" discusses the state of the bond market and large inflows into bond mutual funds by investors seeking returns and attempting the avoid the risk that they see in the stock market.

A key element to understanding this or any other analysis on bonds is the difference between holding an individual bond to maturity vs. buying a fund that invests in bonds.  They behave very differently.  If you buy an individual bond and hold it for its life, unless that company goes bankrupt or has some sort of liquidity event, you will receive back your principal at some point in the future and interest payments along the way.  Unless you are unlucky and it goes into default, it is a predictable stream of payments.  Bond funds, on the other hand, invest in a whole range of individual bonds and do not necessarily hold them to maturity.  Bond funds are significantly impacted by interest rates; when interest rates RISE, the value of their bond holdings immediately falls and investors receive losses.  If interest rates FALL, investors in bond mutual funds receive gains.  Thus holding individual bonds, once purchased, is mostly about default risk for that particular issue, while investing in bond mutual funds is primarily about the direction of interest rates and also overall default risks across all issues.

This situation is summarized as such in the article:
Interest rates will likely rise in coming years from a base of almost zero today.  But investors mostly only know what they have seen in the past 25 years, which for the most part has been period of steadily declining interest rates and rising bond prices.
There isn't any "up side" to bond mutual funds right now, from an interest rate perspective, because rates are almost at zero.  If rates are going to change they are going up.  In addition, low interest rates means less pressure on entities that require debt financing, and rising interest rates will not only slam bond fund values but they will increase the default risk on bonds in the fund as those entities must pay a higher price to refinance future needs.
Compounding the problem is that many investors don't remember when bond funds did lose money for a prolonged period.
The stagnant stock market over the last decade or so, as measured by the major indexes, along with terrifying swings in-between, are pushing individuals away from the stock market.  I remember when I first (naively) started investing in the early 1990's in my 401(k) and telling my peers that they were crazy not to be 100% in stocks, especially since it was a long way to retirement.  While I am still in the stock market today, I would never give that sort of advice now and I believe that the guidance that you should be heavily invested in stocks when you are younger often goes too far when the % of stocks in portfolio climbs above 75% or so.

The same types of "herd" thinking are working in reverse for the bond funds.  Since they have only MADE money over the last 20 or so years, they are viewed as low risk, when really a huge portion of that gain is due to our policies favoring low interest rates which results in gains for bond funds and also lowers default risk.  As these forces turn around when interest rates go up, many individuals are likely to be surprised by the impact to their portfolio of remaining heavily invested in bond mutual funds.

While bonds may have issues, it doesn't mean that you have to pile back into the stock market.  Bond mutual funds are often used as a (sloppy) proxy for "safe" investing, which earns a return but doesn't put much principal at risk.  You can achieve that same goal with safer debt instruments such as certificates of deposit or short term treasuries.  If you are in a bond mutual fund you should not view that money as "safe" - you should view it substantially at risk should interest rates go up or if default rates pick up significantly.

Cross posted at Chicago Boyz and Trust Funds for Kids

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