The global economic cycle has long been hostage to boom and bust, and inevitably valuation bubbles inflate and then burst. In 2000, it was Internet and tech stocks. In 2005 to 2008 it was a housing and credit bubble. Now in 2010, there is a debate over whether or not we are in a bond bubble.
Whether we are in a bond bubble or not is one question. But another more important question is, “What does a bond bubble mean to the average retail investor?”
Deciding on whether it is a true bubble or not is something that will only be known in time. If the Federal Reserve’s FOMC keeps interest rates at near-zero on Fed Funds and keeps buying longer-dated securities, bond yields can easily remain near record lows for that “extended period” that Ben Bernanke keeps talking about. The inverse relationship between bond prices and yields always exists, bubble or not – with lower and lower yields generating higher and higher prices on longer-dated Treasury bonds.
Bond bubbles on the short-end of the curve have no real inherent catastrophic risks for most investors. This is measured by duration, which is more of a valuation measure against time to maturity for each 1% rise in interest rates. An investor can get about 0.24% yield for a 1-year T-Bill yield today. Even if rates magically rose to 0.5% from the near-zero rate today, that investor has no real concern about losses. Likely, it is less than a -1% loss in market values because one year isn’t all that long in the greater scheme of things.
When investors “chase yield” by going farther out on the yield curve for longer-dated maturities, however, that is when risks increase. The 10-year yield is currently around 2.69% and the 30-year yield for Treasuries is approximately 3.81% — enticing considering the volatile market. But real returns aren’t that simple.
Bond investors need to take into account “duration,” or the sensitivity of bond prices to interest rate movements. It broadly corresponds to the length of time before the asset is due to be repaid. Sure, Uncle Sam will always pay that face value of the bond back at maturity, but many investors can’t just take the “buy and hold to maturity” attitude – especially for 30 year bonds.
While coupons and other measures can slightly alter duration calculations, the modified durations according to a Bloomberg report on September 14 of the on-the-run 10-Year T-Note was 8.656 and the modified duration of the on-the-run 30-Year T-Bond was 17.649.
So let’s break it down: If an investor chases yield for the mere safety of today to avoid stock risks and buys a 10-Year T-Note at 2.69% yield, a sudden rise of 100 basis points uniformly on the yield curve would imply that the investor could lose 8.656% on a new mark-to-market value. By going out for that 30-Year yield of 3.81%, an instant rise of 100 basis points in rates would suddenly imply a loss of 17.649% on a mark-to-market basis. Again these are approximate numbers and assumes an instant change rather than a gradual rise through time. Still, this shows that there is no free lunch and that there are risks even in “principal protection.”
So how can investors go for the safety of a Treasury yield, protect themselves from inflation and deflation, and protect against massive price risks due to duration? TIPS, inflation adjusted Treasuries, are the safest bets there outside of the near-zero yields of Treasury Bills. These adjust with the rate of inflation, cannot go under zero on rates, and they adjust periodically as rates change. Then there is of course a whole host of bond ETF products, and does not include corporate or mortgage debt instruments.
For investors who want to be able to buy and sell ETF products for the longest-end of the curve, the most popular ETF for long-term Treasury exposure is the Barclays 20+ year Treasury Bond Fund (NYSE: TLT), which has almost $3.3 billion in assets. If you are absolutely convinced that long-term rates are way too low and that yields have to rise sharply, there is the ProShares UltraShort 20+ Year Treasury (NYSE: TBT) ETF which is very active and seeks to generate 200% of the inverse of the daily performance of the Barclays Capital 20+ Year U.S. Treasury Bond index. That one is extremely volatile and it uses derivatives rather than just buying and selling long-dated maturities.
One example of why there may be a bond bubble is that you have seen in the last week a wave of corporate bond filings and offerings where corporations with solid credit ratings are capturing money for the lowest interest rates in corporate history. IBM (NYSE: IBM) and Johnson & Johnson (NYSE: JNJ) managed to get bond yield offerings of nearly 1.0%. That may just be smart management securing cheap money. Even mortgage rates went under 4.50% for 30-year mortgages if you could qualify. But low rates alone won’t make the case of a bubble.
On the short term side, there is also the Barclays 1-3 Year Treasury Bond Fund (NYSE: SHY) which currently has more than $8.7 billion in assets. To show that the volatility is low here, the $84.22 price today compares to a 52-week range of $82.88 to $84.38.
The 52-week range on the 20+ year ETFs: the ProShares UltraShort 20+ Year Treasury trades at $32.76 and the 52-week range is $29.77 to $51.21; and the iShares Barclays 20+ Year Treasury Bond ETF trades at $103.37 and the 52-week range is $87.30 to $109.34.
The argument is still out over whether there is a true bubble or not. Economists are still fighting over whether the US is headed into a double-dip recession or just a growth environment. There is not even a consensus over whether the world economy is headed into a period of inflation or a period of deflation.
So is there a bond bubble? It just depends upon whom you talk to. There are ways to invest around the Treasury curve for all strategies — just don’t get suckered into the notion that there is no such thing as a risk in Treasuries. Maybe instead of considering this a bond bubble, maybe there is a principle of principal protection.
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