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Bond Bubble, I Think Not! (IEI, IEF, LQD, BND)

Bond Bubble, I Think Not! IEI, IEF, LQD, BND

Is there a bond bubble today? Many well known investors and portfolio managers certainly seem to think so.

In fact about a month ago Jeremy Siegel came out with an article in the Wall Street Journal proclaiming a huge bond bubble was about to burst, even comparing this to the technology equity bubble of the early 2000s.

In addition almost every portfolio manager and guest on CNBC within the past 5 months has been warning of the bursting of the bubble, with equities the clear preferred investment.

Although quality equities should indeed have higher returns over the next 10 years compared to bonds, this should ALWAYS be the case. If a less risky asset is expected to return the same or more as a risky asset why ever buy the risky one? However the ‘bubble' talk in my opinion is dead wrong.

Although chances of significant further capital appreciation on fixed income investments is low, chances of devastating near term large increases in interest rates, are EXTREMELY LOW. And this is what would need to happen to cause a ‘bursting of a bubble'.

Interest rates are not going anywhere anytime soon, for if they did mortgage rates, the housing market, the economy, and the equity market would falter. The FED keeps telling you interest rates will remain extremely low for an extended period of time, but no one wants to believe it.

Over the past century the 2 largest single calendar year 10 year Treasury yield increases were +2.0% from 1979-1980 and 2.5% from 1980-1981. Besides these two years there were several increases in the 1.5% range (2009 was one of these years).

Let's take a hypothetical portfolio composed of 25% Ishares 3-7 Yr. Treasury (NYSE: IEI), 25% Ishares 7-10 Yr. Treasury (NYSE: IEF), 25% Ishares Investment Grade Corporate Debt (NYSE: LQD), and 25% Vanguard Total Bond Market Index ETF (NYSE: BND). This is an extreme example as almost all investors should have some allocation to bonds and equities, but it will illustrate the point nicely.

In 2009, a year where interest rates increased as much as in any time in history (besides 1979-1981 on an absolute basis) this portfolio would have returned +2.36%. This is the doomsday scenario the bond bubbleistas are presenting. Not quite comparable to the -80% or so technology stocks experienced in the 2000 implosion.

This is not to say longer duration bonds are not risky at this point, but if you keep duration reasonable (the example portfolio has duration of 6 years), bonds still should be an important part of most investor's portfolios.

Needless to say I have a strong feeling a lot of managers will be waiting for a bubble to burst, when in reality it never formed.


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